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Searching for Villains and Victims The financial crisis is front page news and will be for a long time. Many people think they know what caused the problem and have an opinion about how to fix it. Most are wrong. To find the road back to prosperity, the first step is to identify where we went astray. Let’s identify the villains. Lock them up and make sure that no one creates this kind of mess again. Meanwhile, all of the victims can get in line for their fair share of the bailout. Well, easier said than done. In this instance, there were a lot of mistakes, but no truly evil villains. Furthermore, we can’t compensate victims because everyone will be in line – compensating victims is a lot like taking money out of your left pocket (via taxes) and putting it into your right pocket. This is like Pandora’s Box, we can’t put things back the way they were or just wish our way back to prosperity. This book will replace a lot of the misinformation about the economic crisis with facts about how the financial markets work. The road back to prosperity is to provide the incentives necessary for a market economy to work. Let’s start by examining the likely villains. The highest profile suspect is Alan Greenspan. In his role as chairman of the Federal Reserve, Greenspan was responsible for setting interest rate policy during the time that the housing bubble expanded. From early 2001 through mid 2003, the Fed Funds rate was lowered from 6.5% to 1%, where it stayed until the middle of 2004. Ironically, these rate cuts were implemented to battle the recession arising from the bursting of the technology bubble. This recession lasted from March to November 2001, so it is easy to say that the continued rate cuts were unnecessary and fueled the housing bubble. Of course, hindsight is wonderful. We can ignore the impact of the 9/11 terrorist attack and the debate about Iraq (the war began in March 2003). Both of these events made it difficult for the Fed to know when the economy was safely out of the 2001 recession. More on point, the Federal Reserve set the Fed Funds rate, not mortgage rates. While Fed Funds came down 5.5%, the thirty year mortgage rate fell only 2.15% (from 7.38% to 5.23%) and then rose half way back during the year that the Fed held rates at 1%. By June 2004, thirty year rates were 6.29%. More importantly, housing price appreciation was highest when rates were increasing in late 2003 through 2006. The exact opposite of blame Greenspan is to blame Americans. The United States has become a “debtor nation” with large debts across all categories. The amount owed by governments (both federal and state and local) has jumped about 12-fold over the past three decades. Household debt is up about 19 times. Leverage in the financial system has grown the most of all – about 55x! Isn’t debt the source of the problem? To understand debt, you have to realize that for every debtor there is a lender. Instead of calling it a debt crisis, we might just as well say we have an investment crisis. There are too many lenders! Debt can balloon in the financial sector because every financial institution is both a borrower and a lender. For example, one bank may lend to another, who lends to another, and another, etc., until one lends funds back to the first bank. The money goes full circle, but with each step debt increases. To reduce debt, just unwind this series of transactions. If this example was indicative of the true situation, debt would not be a problem. In reality, the debtors and lenders are often separate constituencies. The fear is that debt can unravel – one borrower defaults, pushing another over the edge, and another, etc., until it all comes crashing down like a house of cards. In this scenario, the villain is the first one to default. That is the one who triggers the crash. Who is this villain? Usually the subprime borrowers who bought houses that cost more than they could afford. Setting aside the fact that this group is usually portrayed as the victim, let’s examine the proposition offered to these borrowers. Buy a house worth several times your annual income (say 10x) with no money down. If the value goes up, either pull out that equity via a cash-out refinancing or let it ride (it will be the majority of your personal net worth). A 10% increase with 10x leverage is equivalent to doubling your income. In the event that the property goes down in value (or does not go up enough), you walk away with a bad mark on an already weak credit report. Who wouldn’t jump at this opportunity? Unfortunately, many of these borrowers didn’t see themselves as gamblers getting a free spin on the wheel of fortune. They thought they had found the secret to getting rich. The borrowers who feel like they’ve lost the most are the ones that were lucky enough to get in early. As soon as housing plateaus, “income” from the cash out refi evaporates. The equity that grew out of house price appreciation evaporates with price declines. When housing prices fall their “nest egg” is gone. Easy come, easy go. A borrower who cannot afford to meet the payment obligations without an increase in the house price is really a real estate speculator. To blame speculators is to indict America’s entrepreneurial spirit. In the United States, people are encouraged to evaluate risks and rewards and take chances to improve their lives. The real problem with this real estate speculation was that the potential gains and losses were not appropriately balanced. There was too much upside with relatively little downside. Then the villain must be the housing finance system which misjudged the risks and rewards. Where did the housing finance system fall apart? Mortgage brokers often are the first targets. Mortgage brokers are the independent salesmen that work with borrowers to obtain a mortgage loan. Subprime brokers are the used car salesmen of the mortgage industry. They are usually despised on two accounts: abetting (or committing) fraud on mortgage applications and earning too much money. On the dishonesty charge, many brokers plead “standard industry practice.” In fact, mortgage programs which did not require verification of income and/or assets were often called “liar loans.” Better yet, these stated income/stated assets loans (with no verification) eventually gave way to loans where the borrower wasn’t required to lie – no income/no assets were disclosed. Broker compensation is more difficult to assess. By earning a relatively small percentage (1-3%) of very large mortgage amounts ($100,000 or more), brokers stood to earn thousands of dollars on every loan that closed. Moreover, by getting paid at closing, brokers have no incentive to ensure that the loan works for either the borrower or lender. This compensation structure resulted in conflicts of interest between the brokers, borrowers and lenders. Conflicts of interest occur everywhere. At the market, every shopkeeper wants a higher price and every customer a discount. Despite this weakness, the mortgage brokerage system worked well compared to the alternatives. In most cases, brokers seek to establish a long term relationship with the borrower so that they will be engaged for subsequent transactions. In fact, virtually all subprime mortgages (and the vast majority of prime mortgages) are refinanced prior to maturity, so the broker stands to earn a second (and third) commission by providing good service to the borrower. This incentive encourages the broker to provide good advice to borrowers. Similarly, brokers need to maintain good relations with lenders or they will be cut off. Even if lenders wanted to do all mortgage origination in house, it is difficult to staff up fast enough to keep pace with a refi wave. Lenders needed brokers to manage the volume of loans. It’s hard to like brokers, but it’s equally hard to blame them for the financial crisis.1 If not the brokers, then maybe the problem was product design. Should borrowers be allowed to buy too much house? No down payment? No documentation? Teaser rates? No (or negative) amortization? There are good reasons for each of these product features. Unfortunately, there are just as many misuses. Too much house: it’s easy to posit the growing family, big raise, or other great expectations that would justify a larger house than the borrower can afford right now. Worse yet, everyone involved in the transaction is bullish on real estate, so none see the risk if those great expectations aren’t realized. Nothing down: a borrower without a down payment and without credit card debt is better than one who has both. No docs: self employed, commissions, bonuses. How do you document your future income? After all, historical income alone won’t pay the bills. Attacking mortgage product design winds up like debating gun control – guns don’t kill, people do (but they only use a gun if it’s available). One might just as well say mortgages don’t default, borrowers do. But certain kinds of mortgages are more likely to default than others. Since we have a wide variety of mortgages, and we acknowledge that some features are risky, are the lenders to blame for inadequately assessing the risk? Lenders should evaluate all of the risks associated with a loan and deny any that do not pass muster. Such underwriting requires experience and judgment. However, in recent history, financial models have proven more reliable than personal expertise. As it turns out, people have biases which affect their judgment, and models are not prejudiced. By focusing on the data, lenders can correct for bias and make more accurate lending decisions. Unfortunately, the models have been proven wrong. Horribly wrong. Let’s blame the quants! Quantitative modelers take information from historical loan performance to build models which project future performance. For example, a model can compare the performance of two groups of loans which are identical except for the amount of the down payment. This data could be used to predict the impact of alternate down payment requirements on loan losses. This information enables the lender to make trade-offs among various loan features to underwrite the loan. Of course, the data did not cooperate. History did not repeat itself, and loan losses began to exceed model expectations. Does this mean we would be better off without the models? Hardly. The model provides insight into the likely impact of alternate features. Insight is valuable, but it is not a guaranty. A side effect of the rise of models is securitization. Securitization is simply the process of grouping together assets and issuing securities representing ownership thereof. For example, a group of 1000 mortgage loans, at an average of $200,000 each could form the basis for a $200 million securitization. In aggregate, the investors in the securitization would receive the same cash flows as the owner of the 1000 loans. In practice, quantitative models enabled securitizers to slice and dice those 1000 loans many different ways to allocate risk. Some investors could be protected from credit losses on the loans; some could choose short term payments. Of course, for every protection granted, a new exposure is created. some other investor would need to take the credit risk and the long term payments, 1 Beginning in 2007, watching mortgage companies blow up became a spectator sport when the website mortgageimplode.com was launched. The site lists the companies that have imploded along with links to announcements about their demise. With reputations as villains, most observers cheered each announcement that another subprime lender was going out of business. Since these companies implode under the weight of their own mistakes, there is no need for regulation or laws to put them out of business. respectively. At the end of the day, the question is whether the sum of these parts is worth more than the whole group of loans; securitization only works when this is true. Securitization is blamed for making finance too complicated. Nothing could be further from the truth. Nothing here is more risky than the vagaries on an individual mortgage loan. Is a lender better off holding loans which cannot be securitized or securities representing interests in those same loans? The only difference is liquidity, and some liquidity is always better than none. The complication comes with the slicing and dicing process. That said, a lender better off with securitization – parsing loans into several tranches and keeping only the relatively safe ones. The risk shifts to investors in the inverse positions where the risk is concentrated. As it turns out, the financial crisis spread among the “safe” securities rebutting the notion that securitization caused the problem. Perhaps the securitization process, per se, is fine, but it leads to a disintermediation of risk analysis between lenders and investors. That is, what if the investors don’t really know what they’re buying? Mortgage backed securities’ prospectuses are inordinately complicated, and many investors probably do not fully understand the risks. Is the crisis all investors’ fault? Like borrowers, investors are really the victims, the biggest victims. Of course, some investors saw the housing bubble and bet against MBS. These investors made a lot of money when their predictions proved accurate. Are these contrarians the real villains? Contrarians, especially short-sellers, often elicit negative reactions, but villainizing the winners removes any incentive to seek the truth or make a contrarian bet. The market would cease to function. Instead of contrarians, let’s focus on relatively passive investors. Shame on anyone who invested without knowing what they got! These investors may have relied on Wall Street research or the rating agencies. Rather than just blaming such relatively passive investors, let’s also focus on the watch dogs. The rating agencies are accused of pandering to issuers (another conflict of interest argument), but they are primarily faulted for getting it wrong. Like securitizers, rating agencies used quantitative models to predict the cash flows on various securities and, thereby, assign ratings. Like securitizers, their models proved wildly inaccurate. Perhaps the problem was inevitable because rating agencies are paid by the issuer of securities rather than investors. Presumably this gives rating agencies an incentive to overstate the credit quality of deals. Of course, investors could compensate for an upward bias in credit ratings by adjusting their bids. In fact, towards the end of the MBS boom, a few investors paid higher prices for so- called “quadruple A” tranches which had even more credit protection than the rating agencies required for their highest ratings. Coming full circle, the last suspect for the villain is the Federal Reserve but this time in its role as regulator. Hindsight is so clear that many observers say “where were the regulators?” as if regulators could have prevented this catastrophe. Regulators have a relatively narrow mission. Each has a designated group of regulated enterprises. Each of those has a designated list of required reports. Each has a designated list of prohibited activities. This regulatory construct is designed to provide guard rails for the financial system, not to prescribe exactly how participants should compete. If it were easy to identify the villains and fix this mess, it would already have been done. As with villains, it is hard to find a worthy victim. While every participant in the financial markets made mistakes, no one is the sole source of the financial crisis. Similarly, nearly every participant has been harmed by the housing bubble, financial crisis, and resulting economic weakness. The trick is to ascertain who, if any, bore the brunt of the losses. Then we can examine their role in the fiasco to determine who deserves a bailout. At this point, we can only think about the victims so far. As the recession continues and the federal budget deficit balloons, the ultimate victim, the American taxpayer, bears more and more of the pain. The first step is to containing the crisis (and ending the pain) is to stabilize the housing market. Until we know where the bottom is, we don’t even know how bad the damage is. For housing, the first victims to consider are mortgage borrowers. Prior to 2007, foreclosures were relatively rare. The United States had never experienced a nationwide housing price decline, so most foreclosures resulted from idiosyncrasies affecting a particular borrower. Foreclosures were usually tied to losing a job, a divorce, a significant expense like medical bills, or some other unforeseen event. Even with such an event, many borrowers avoided foreclosure because they could sell the house for more than the balance on the mortgage. When the housing bubble burst, all of this changed. In 2007, payment shock foreclosures appeared. Many mortgages were designed like time bombs: after a few years, the payment would adjust to reflect a higher interest rate and principal amortization. The only way the borrower could survive was to refinance that mortgage with a new loan. Of course, that exit strategy went up in smoke when housing prices declined. Without sufficient equity in the house, the borrower could not refinance; nor could the borrower afford the new monthly payment. Foreclosure became a foregone conclusion. Are borrowers facing a payment shock worthy victims? Some of them are simply speculators – they bought a house with no money down and their bet didn’t pan out. In this case, it is more appropriate to say “they didn’t win” than “they lost.” Some of these “victims” even won the first few rounds of the housing lottery. They took cash out and spent it, living better than they would have without the house. Others paid less on their mortgages than they would have to rent a similar house. Again, a winner not a victim. In all fairness, many of the borrowers in this housing lottery didn’t know they were speculating. They were proud homeowners with “a man’s home is his castle” attitudes. Many of these borrowers either did not understand how their mortgage payment could adjust or did not believe that housing price growth would ever slow, making refinancing impossible. They feel tricked. While it is easy to empathize with their feelings, many of these borrowers still won the housing lottery just like the speculators did. They just feel bad because they didn’t win the last spin of the wheel. There are, of course, victims among these borrowers. Borrowers who put in a reasonable down payment and made their payments, but found that the mortgage market had dried up when they needed to refinance. Losing the house means losing their life savings (the down payment). Others were the victim of equity stripping whereby the commissions and fees on the mortgage loan (or series of mortgage loans) reduced the borrower’s home equity. There are, of course, many other homeowners who are caught up in the housing crisis. Many borrowers that avoided the exotic mortgages which created the crisis still have a problem because their refinancing opportunities have dried up. Even homeowners without a mortgage have been harmed by the drastic fall in house prices. Homeowners can’t sell or move when their house is underwater. Worse yet, the recession makes it more likely that people will lose their jobs. Foreclosures among this segment, still tend to be a small percentage, but they generate a lot of sympathy. Just as borrowers appear to be both villains and victims, perhaps we should search for victims among mortgage companies. While there are undoubtedly some good people who were caught up in these implosions, the list better serves as a who’s who of the villains. The victims are more likely to be the financial institutions who bought the loans. In fact, most of the bailout activity to date has been directed at these financial institutions. Take, for example, Bear Stearns. Bear Stearns was an investment bank that had a significant presence in the mortgage finance market. In March 2008, Bear Stearns was unable to roll over its debt obligations. The resulting liquidity crisis meant the demise of the firm. In negotiations over one weekend, the Treasury and Federal Reserve convinced JP Morgan Chase to buy Bear Stearns and assume its obligations. Stockholders were all but wiped out (they got $10 per share when the stock had been worth $160 less than a year earlier). Lenders fared better – their obligations were assumed by JP Morgan Chase. Employees had an opportunity to compete for jobs at JP Morgan Chase, but the combined company shed thousands of jobs during 2008. Instead of a Bear Stearns bailout, this transaction was really a bailout of lenders to Bear Stearns. Shareholders and employees suffered the most from Bear Stearn’s failure, but few would argue that they were victims. Because Bear Stearns was a significant player in mortgage finance, we presume that shareholder and employee losses were justified by their culpability in the crisis. After the Bear Stearns “bailout” two events during the summer set the stage for the “catastrophe of the week” we experienced in September and October of 2008. First, IndyMac, a $32 billion California thrift, was seized by federal regulators after it experienced a run on the bank when Senator Schumer publicly questioned its viability. One month later, Congress passed the Housing and Economic Recovery Act which strengthened the regulatory oversight of Fannie Mae and Freddie Mac (the GSEs). With the stronger oversight, Treasury had the right to support the GSEs. Almost immediately, market watchers referred to Treasury’s role as a “blank check” and suggested that government support was inevitable. Like Bear Stearns, IndyMac’s shareholders were wiped out. Depositors were largely covered by the FDIC’s deposit insurance, so they came out whole, though many were worried for a few weeks. Aside from the management team, most employees survived. Most interestingly, IndyMac’s borrowers did very well. Under FDIC control, IndyMac took the lead in modifying mortgages to reduce foreclosures. Many modifications were very favorable to borrowers. As with Bear Stearns, shareholder and management losses at IndyMac’s are thought of as fair. When a bank fails due to concentrations in its portfolio (also viewed as poor choices by management), that bank is not really a victim. The next shoe dropped on September 7, 2008 when the bailout of the GSEs was announced. Treasury bought senior preferred stock and took warrants allowing it to buy 80% of the common stock of the GSEs for only $1 per share. As with Bear Stearns, stockholders were all but wiped out. Stocks which had traded at over $60 per share a year earlier were now worth less than $1. More importantly, even preferred stockholders were wiped out. As luck would have it, a lot of the GSEs’ preferred stock was held by banks and thrifts (their regulators had relatively low capital requirements on these GSE obligations). Wiping out the preferred stock quickly rippled through the banking sector. As GSE preferreds were written down, hundreds of banks and thrifts suffered losses and suddenly appeared less well capitalized. With the cost of the IndyMac failure weighing on the FDIC, most expected their regulators to carefully evaluate bank capital. Fear gripped the banking sector and lending activity dropped to a trickle. Surprisingly, many banks who had nothing to do with risky mortgages became victims of the housing crisis. A week after shocking the world with its takeover of Fannie Mae and Freddie Mac, Treasury surprised everyone again by letting Lehman Brothers fail. During weekend discussions, Treasury made it clear that Lehman would not be bailed out like Bear Stearns even though Lehman was a larger investment bank and faced many of the same issues. Over the weekend, Merrill Lynch hastily agreed to merge with Bank of America. On Monday 9/15 Lehman filed for bankruptcy. Although Lehman’s failure led to bankruptcy and Bear Stearns to a bailout, the outcomes were really very similar. Lehman shareholders lost everything; Bear’s lost almost everything. Lehman employees were on the street for a week, but Barclays picked up the core U.S. operations and Nomura took most of Asia. Lenders who were collateralized probably came out whole. A few lenders, most notably commercial paper investors, came up empty. The disparate treatment of Bear Stearns and Lehman shocked the markets. Commercial paper suddenly became a risky investment. No one knew who would default next. While all of Lehman’s commercial paper investors took a loss, Reserve Primary Fund, a $65 billion money market fund, was hurt more than the rest. Their concentration in Lehman paper was relatively large (1% of assets), so the Lehman write- off exceeded their interest income and the money market fund “broke the buck.” Investors in this mutual fund lost confidence and took their money out of the fund. To stabilize other funds, Treasury announced a program to guaranty money market fund investments on Friday 9/19. A day after Lehman’s failure, Treasury was at it again. They decided to rescue American International Group (the world’s largest insurance company) on 9/16. That night, the rating agencies downgraded AIG from triple-A to single-A. This move triggered collateral calls whereby AIG would be required to post more assets to support its obligations – assets that it didn’t have. In addition to its insurance operations, AIG was one of the largest players in the credit default swap market. Many financial institutions had hedged their exposure to credit risk by swapping with AIG. Treasury feared that if AIG went down, many other institutions would go to. The financial crisis was accelerating. By Friday, Treasury was eager to bolster confidence in the financial markets. The isolated cases of Bear Stearns and IndyMac had morphed into domino effect failures of Freddie Mac, Fannie Mae, Lehman, and AIG. The common cause in all of these failures was the lack of market liquidity for private label MBS. No one knew how bad the credit losses would get, and no one was able to hold the bonds. The CDS market was not even available to hedge the risk. There simply was no market. To solve this problem, Treasury came up with the Troubled Asset Relief Program (TARP) wherein Treasury would buy up these assets. The program was outlined on 9/19 and legislation was enacted two weeks later (10/3)2. The weekend after the TARP program was announced, Goldman Sachs and Morgan Stanley (the last two large investment banks) agreed to become commercial banks. As commercial banks, both would be subject to more regulatory oversight, but both would be eligible to sell assets into TARP. Most importantly, both would be subject to bank capital rules which would require substantial de-leveraging. 2 The first vote on the legislation failed on Monday 9/29, triggering the worst day ever experienced in the stock market. Apparently this rattled lawmakers, who passed a new version of TARP four days later. With Merrill, Lehman, AIG and TARP in the news, the run on Washington Mutual received scant attention. In ten days (from 9/15 to 9/24), the thrift lost almost 10% of its deposits ($16.4 billion). At the time, WaMu was by far the largest thrift in the country. Whereas regulators normally take-over failed institutions over a weekend, the Office of Thrift Supervision seized WaMu on Thursday 9/25. WaMu’s operations were flipped to JPMorgan Chase which re-opened the next day. Over that weekend, regulators sought to pre-empt the next failure by forcing Wachovia into the arms of Citigroup. The deal was announced on Monday 9/29 only to be superseded by a better offer from Wells Fargo on 10/3. Either way, Wachovia was gone. September 2009 say the demise of seven of the largest financial institutions in the world (Fannie, Freddie, Merrill, Lehman, AIG, WaMu, and Wachovia) and massive restructuring of five others (Goldman, Morgan Stanley, JPMorgan Chase, Citigroup and Wells Fargo). Every large investment bank and every leading commercial bank was involved. Within a week of passing TARP, its original purpose was scrapped. After negotiations over the Columbus Day weekend, Treasury announced that funds would be used to buy preferred stock in financial institutions instead. Leading financial institutions were strongly encouraged to participate so that smaller institutions would not be ostracized if they participated. Preferred stock purchases under TARP were intended to be investments rather than a bailout, and the government wouldn’t be picking winners and losers. The concept of letting markets work ended a week later. Following the 10/14 announcement, large regional banks began applying for TARP investments. On 10/24 NatCity was turned down – a clear vote of no confidence by its regulators. This forced NatCity to merge with PNC. This announcement, while smaller than the rest, was the capstone. It proved what the preceding two months should have demonstrated – the regulators were deciding how to manage all of the major financial institutions. Among these financial institutions, were any victims? Hardly. Shareholders and employees suffered, albeit to varying degrees. Of course, equity losses are exactly what we should expect when a company fails. Making shareholders “victims” runs counter to the whole idea of risk capital. Risk capital is the foundation of capitalism. Employees can make a better case as victims: the vast majority were not involved in the activities that took the companies down. That said, are these people more worthy than others who are losing their jobs as the recession worsens? Besides, many employees still got large bonuses for 2008. The “victims” who benefited from the bailouts were the lenders to the failing companies. Most of the creditors have come out whole – and most would have even without any bailout funds. Looking beyond the borrowers and financial institutions who were actively involved as the financial crisis developed, you can name virtually anyone as a victim. When stock prices down over 50%, who doesn’t hear “where’s the bailout for my 401K?” As a result of the financial crisis, virtually every investment has lost value. Investments in the private label MBS, particularly the subordinated tranches, are most closely connected to the housing crisis. Most of these bonds are virtually worthless. As losses wipe out these bonds, the risk to the senior tranches increases and those prices fell too. Investors fled and prices fell. Even MBS without the same kind of credit risk fell as investors compared prices relative to the private label market. This kind of domino effect continued, lowering the market value of virtually every investment. At the time that Treasury was pushing TARP (late September 2009), the U.S. equity market had already lost about $7 trillion in value. Losses on fixed income investments would add to that figure. Investors are truly victims here. The question that all of us should be asking is two-fold: why haven’t government efforts succeeded in stemming the spread of the financial crisis and what should we do instead. Put simply, every action the government has taken has undermined confidence in financial markets. The solution is simply stated: restore confidence. Of course, easier said than done, but this book will proceed by mapping out the inter-relationships between various segments of the financial markets and discuss the key types of financial institutions. Part two will provide a more detailed analysis of the crux of the problem – the mortgage finance industry. Part three looks to the future, discussing both the programs that won’t work (and why) and the ones that will. You will be able to watch for more missteps on programs that will fail without getting your hopes up. You will also see implementation of policies that will work; these will be leading indicators for the end of the crisis.
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