The lending landscape is vastly different from what it was in August of 2007. But as much as it has changed, much of it has remained the same. It’s the part that has remained the same that is worrisome. Incidentally, sub-prime mortgages were not the cause of the meltdown, merely the trigger.
THE RISE OF THE QUANTS
I know “The Rise of the Quants” sounds like some futuristic “Matrix-like” movie title, but it refers to the growth and prominence of Wall St.’s quantitative analysts or “quants” as they’re known on the Street. It was one of a series of steps that led to the mortgage meltdown we’re still mired in. As we shall see, there was no one group solely responsible for the ensuing mess but a number of culprits, enablers, dawdlers, do-nothings along with a confluence of events that led to the “perfect storm” of conditions. Not all, but many of the participants had two things in common—greed and a desire to game the system.
In the past decade, Wall St. investment banks and brokerage firms concocted a dizzying array of new products. To improve credit risk management, Wall Street’s quants (financial engineers) used modern portfolio theory, high interest rate bearing mortgages, sophisticated math driven calculations and Credit Default Swaps (CDSs) to formulate new mortgage-backed securities (MBS). The various iterations produced an alphabet soup of products: Collateralized Mortgage Obligations (CMOs), Collateralized Debt Obligations (CDOs), and Structured Investment Vehicles (SIVs). To give some semblance of portfolio balance they were blended together, with regard to geography, credit type, etc. to garner not only AAA credit ratings but also some insurance coverage. The aim of all this financial alchemy was to concoct a new high return/low risk security with an AAA rating.
But, Wall St. envisioned that even more money could be made if it took the “Hamburger Helper” approach to securitization and used some cheaper ingredients as filler. So it carved up mortgages and salted “tranches” or slices of sub-prime loans with BBB (i.e. junk) ratings with prime (AAA) mortgages, repackaged them, redistributed the risk, and sold these new creations both here and abroad. The net results were securities that were not only inscrutable to experts but even harder to value. (Even many of the principals running the investment firms didn’t understand the arcane risk models that that their quants had devised). In the final analysis, it became apparent that no amount of manipulation could turn a non-prime mortgage into an AAA security or that by redistributing risk, it eliminated it.
These securities were bundled into bonds with a cascading cash waterfall so that the top tiers were paid out thereby allowing them to be rated AAA. By salting AAA paper with riskier sub-prime (but higher yielding bonds) Wall Street magically created a new higher yield security comprised of up to 80% of “AAA” bonds, yet still rated AAA by the ratings agencies. Various ratings agencies like Moody’s, Standard & Poors, and Fitch were employed to grade these securities. Different agencies would review a residential mortgage-backed security, but only one company would get paid for its services, typically, the one that offered the best rating. As a result, ratings agencies benefited from relaxing their ratings standards in order to get the business. At the same time, this obvious conflict of interest hardly insured “objectivity” since the ratings agencies were being paid by the very issuers whose bonds they were rating, not the investors. Despite being seriously understaffed for the task at hand and having only a loose familiarity with the quality of the assets behind these instruments, the agencies set the credit standards that determined which loans Wall Street could repackage and, ultimately, which borrowers would qualify. In a sense, they did the job that was expected of government regulators and ironically became the de facto watchdog over the mortgage industry.
These triple “A” rated securities were then marketed to domestic insurance companies, hedge funds, banks, foreign investors, money market funds and wealthy individuals. The creative use of leverage, layered options (derivatives) and a platinum risk rating led to an almost unlimited demand for this structured paper—and the sales volumes grew into hundreds of billions.
Buyers, at the very least, should have suspected that the securities they were buying had above-normal risk, since they had above-average yields and as every undergraduate business student knows—high return and low risk do not go hand in hand. Although everyone knows that there is no such thing as a free lunch”—but just as with the Dot-Com bust years earlier a lot of people were gulled into believing that this time it was different—that there was a new economic paradigm.
HOT POTATO—PASS IT ON!
As for the lending abuses that occurred with aggressive mortgage lenders, they stemmed from the wanton disassociation of risk. Because of the rapid securitization of mortgages, lenders weren’t placing their own balance sheets at risk when underwriting loans. They were paid for quantity, REGARDLESS of quality. The balance sheet risk was transferred through three entities in less than 90 days from origination. The originator would originate ANYTHING he could sell to a whole loan buyer to pass on to Wall St. With diminished risk Lenders were more willing to extend credit to not only marginal borrowers, but to devise new even more loony loan programs [e.g., stated income loans for W-2 borrowers or “liar loans”, No Income, No Job, and No Assets loans a.k.a. (NINJAs), Negative Amortization Mortgages, and Interest Only loans (no principal repayment mortgages)] to increase their volume. This transference of risk was (is) the crux of the ensuing mortgage debacle.
THE SHADOW MARKET ON STEROIDS
Another part of the problem was that financial regulation and oversight had not kept pace with the burgeoning growth of an unregulated parallel banking system or “shadow market”. Indeed, owing to securitization, investment banks and hedge funds had grown far larger and more powerful than their regulated, commercial brethren. (Today, the investment banks and hedge funds trade privately in one of the fastest-growing and most lucrative products on Wall Street—derivatives. These products are virtually hidden from investors, analysts and regulators, even though they have emerged as one of Wall Street’s most outsized profit engines. The derivatives market is huge, unregulated, hard to understand, and harder to value. Ironically, the more complicated the financial instrument or leveraged the institution, the less likely it is to fall under government oversight).
Again, due to their newness, credit default swaps are wholly unregulated. These instruments were created as insurance contracts that banks and bondholders could buy to cover losses when companies fail to pay their debts. Like the derivatives market, the outstanding value of the swaps has exploded from $900 billion in 2001 to more than $62 trillion, today. To put it in perspective, that is about equal to 70% of the total US household wealth and about seven times the national debt. The market is totally unregulated and these days firms are so interlinked with one another and with other market players that they do not know whether their counterparties, as they're called, have adequately protected themselves. If and when defaults occur, some of the counterparties are likely to prove unable to fulfill their obligations. These products were designed to mitigate risk, but given their stupendous growth they have the potential to wreak havoc on the financial system. Their being unregulated and largely untested further leaves one with an uneasy feeling that herein may lay another instance of an accident waiting to happen. It is believed that this was another reason that the Federal Reserve stepped in to bail out Bear Stearns.
NO OVERSIGHT, IN SIGHT!
Obviously, the investment banks, mortgage lenders and bond rating agencies that packaged, rated, and sold these toxic securities were miscreants. But, there were other parties and individuals that were cognizant of the risks but whose inaction allowed this “perfect storm” of conditions to grow unabated. Though various federal regulatory agencies like the SEC and the Federal Reserve were entrusted with oversight responsibilities to protect the commonweal, only a few individuals voiced alarm at what they saw occurring—the majority of them adopted a policy of “go-along to get-along”. The SEC effectively told Wall Street to police itself to save on regulatory costs. Compounding the situation, these CDOs, CMOs and SIVs were (are) leveraged with complex derivatives and linked with the phenomenal growth of the credit default swaps. Some days, half of the trades on major stock exchanges come from so-called black boxes programmed with everything from binomial trees to algorithms. Yet, most federal securities regulators couldn't explain these exotic instruments with alphabet-soup initials, much less monitor them, nor do they have any idea what they are really worth.
The former chairman of the Federal Reserve, Alan Greenspan, certainly has to accept a measure of blame for enabling the housing bubble to grow unchecked. He cut the Fed Funds Rate to 1% in 2001 to counteract the effects of the Dot-com bust and 9/11 and it was his policies that kept interest rates historically low for a prolonged period and his endorsement of administration tax cuts which helped to propel housing prices to unsustainable heights. Even though he iterated concerns over "froth" in the market in 2005 and stated in reference to the housing bubble that it was “pretty clear that it's an unsustainable underlying pattern” he did nothing to rein in lending practices among mortgage lenders. From 2002 to 2005 there was a massive credit expansion which led to asset inflation. Now, we’re experiencing an equally massive asset deflation in the housing and credit markets.
FOR THE ADMINISTRATION AND CONGRESS—IT WAS POLITICS, AS USUAL
Of our elected officials, the President and the Congress have been largely unresponsive. What little they did was too little and too late. The housing market had been in a terrible slump nine months before the credit crisis began but nary a one of them appeared responsive or concerned. Once the meltdown had begun they could have done much to ameliorate the situation, but like so many of their ilk they simply paid lip service to the fiasco at hand. The President’s bumbling denials regarding the state of the economy, his dithering, do-nothing attitude with respect to the dire slump in the housing industry and his inability to fathom the enormity of the credit crisis was all-too reminiscent of his ill-conceived prosecution of the war in Iraq, and mishandling of the Hurricane Katrina disaster, not to mention numerous other instances of cronyism and sheer ineptitude. Secretary of the Treasury, Henry Paulsen, another lackluster Bush appointee, did little other than echo the sentiments of the man who appointed him.
When decisive action was called for on the part of our many of our lawmakers, we got pontificating, partisan politics and internecine wrangling leading to ineffectual half-measures. Although lawmakers approved a fiscal Stimulus Package it was another case of too little, too late. Even if less partisan measures had been adopted and sooner, given the magnitude of the problem, a recession was probably unavoidable, but given the lead time they had to deal with it, the severity and the length of this recession could have been greatly diminished.
BORROWERS BEWARE OR IS IT BEWARE OF BORROWERS?
The buyers/borrowers who succumbed to the lures of 100% financing weren’t exactly innocents, either. When the housing market began its inevitable decline 18 months ago (“after all, nothing goes up forever”) and the ensuing credit crunch hit last year, the melody of rising prices stopped abruptly in the housing industry’s version of “musical chairs”. Many borrowers soon discovered that they were upside down in their homes (that is, owing more than they were worth) and decided to bail out because with 100% financing many had “no skin in the game” and they couldn’t see the point of throwing good money after bad by servicing a debt, of say $500,000, for years to come on, an asset now only worth $400,000. More conscientious types, struggled to keep up their mortgage payments, but found that they couldn’t refinance because falling prices had eroded their equity, and in the meantime, lenders had tightened their guidelines and lowered their LTV percentages. Many mortgagors who had over-stated their income (on their stated income loans) and were dependent on rising prices to bail them out, succumbed when their interest rates reset. As borrowers began to default foreclosures and short sales mounted, and prices were pushed lower...and lower. Moody’s Economy.com forecasts that three million home loans will have gone into default in the 30 months ending in mid 2009, with about two-thirds of them resulting in foreclosures.
REACTION AND CONTRACTION
These cumulative defaults, in turn, crippled the value of the once prime paper that securitized the mortgages. The demand for this so-called structured paper evaporated—and where there is no market, there is no value. This situation is especially dire where leverage is high, (as with financial institutions) that are interconnected through swaps and loans. (Investment banks and hedge funds equities are routinely leveraged 30 fold). With the inability to buy and sell financial assets caused by a lack of valid information about asset values, market liquidity dried up. As lenders became more concerned about to whom they lent, their reluctance further slowed an economy already in crisis.
By the end of 2007, defaults amounted to nearly 8 percent (2.04% were in foreclosure and another 5.82% were delinquent), banks were reluctant to lend because they had few if any investors to buy these loans. Nor were they buying securities backed by loans because (as we’ve seen) they were unsure of the quality of the underlying assets. As of June 25th of this year, the New York Times reported foreclosure filings across the country had mushroomed to 8,000 a day. In California, in May alone, banks took back 26,000 homes and 74,000 nationally.
Some lenders couldn’t do much because of balance sheet constraints while others held on to funds to shore up their balance sheets. The Fed couldn’t make banks lend and analysts thought banks and investors were unlikely to regain confidence until the real estate market stabilized. Uncertainty about how much farther home prices might fall made banks less willing to lend and consumers reluctant to buy. Exacerbating the situation further, lenders demanded bigger down payments to off-set the declining values in real estate and banks cut off home equity lines of credit to borrowers, especially those who lived in states where home prices were falling fastest which further impeded the housing market’s recovery and slowed spending.
As delinquencies begat foreclosures and short sales and mortgage lenders failed, a few were acquired by more solvent institutions. The most notable of these was Countrywide Financial, the nation’s largest mortgage lender, being acquired by Bank of America. A few month’s later, the Fed hastily arranged a $30 billion loan for JP Morgan Chase to acquire the nation’s fifth largest investment bank, Bear Stearns & Co. The Fed's intervention suggested that were the troubled Bear Stearns to fail, it might lead to cascading failures throughout the world. The failure of one large counterparty, can drag down counterparties all over the globe. And if the counterparties fail, it could drag down the counterparties' counterparties, and so on. The Fed had to do what it deemed fit to avoid calamity. “Moral hazard” as it’s termed needed to be managed to ensure that the rescued did not have the opportunity to jeopardize the system again. Unfortunately, for taxpayers this debacle came to mean that profits were privatized but losses were socialized.
Skip to the next paragraph, March saw signs of panic hit the markets, anew. Thornburg Mortgage Inc., the second largest independent mortgage lender, after CountryWide, and Carlyle Capital, one of the country’s largest private equity firms, failed to meet their margin calls of $670 and $610 million, respectively and were forced to dump significant portions of their 20 billion dollar portfolios on the market to stave off insolvency. As these big investors were forced to quickly dump billions of dollars in securities, trading seized up. In April, Washington Mutual, the nation’s largest Savings & Loan, imploded and withdrew from wholesale lending.
THE FED IN CRISIS MODE
While others have provided little in the way of leadership the new Fed Chairman, Ben Bernanke has shown outstanding initiative. Since last September, Ben Bernanke and the Board of Governors have made seven rate cuts totaling 3¼%. Owing to their losses it was thought that investment banks and mortgage lenders were short of capital and were afraid of not being able to borrow enough short-term money to fund their obligations which caused credit to dry up. But, the real problem was one of solvency. Until January of this year, the Fed still believed that it was a lack of liquidity in the system. And to this end, it injected approximately about $303 billion in short term loans into the banking system via Terms Auctions. This innovation allowed banks in need of short-term funding to borrow money for 28 days, rather than overnight, and the Federal Reserve allowed them to pledge their prime mortgage paper as collateral to obtain a lower interest rate than what these banks would normally get from the Fed at the discount window. He also installed Fed regulators inside investment banks to inspect their books. Despite these implementations, the average rate for a 30-year fixed mortgage dropped only half a percentage point during this time frame, proving that Bernanke and company’s efforts were unable to exert much influence over fixed mortgage rates. While some of the measures initially seemed promising, twenty-five years of accumulated excesses could not be undone by simply cutting rates, increasing the money supply, investment banks adjusting the book value of their assets, and lenders tightening their guidelines. Furthermore, the Fed’s efforts to spur a recovery were hamstrung by inflation: it couldn’t treat both slowing growth and rising inflation at the same time. But as we’ve seen, after all the write downs in book value, the real issue was solvency.
THE ELEPHANT IN THE ROOM THAT NO ONE WANTS TO TALK ABOUT
U. S banks have written down approximately $400 billion in losses since last year. There is probably an additional $150 billion they have yet to write down. On top of this, the Fed has pumped another $228 billion of liquidity into the system. Even so, these numbers all combined only equal about two-thirds of the $875 billion that has been spent in the prosecution of costly, unpopular and unsuccessful war in Iraq over the past 5½ years, not to mention the trillions more that may be expended before we extricate ourselves from there. Moreover, the Bush administration has financed this war by large budget deficits and by foreign borrowing. Forty percent of the increased debt will be held by China and other foreign countries. If the war backers believe that the Iraq War is so essential, then they should be willing to pay for it partly with taxes rather than charging it. For those Americans that believe staying in Iraq does more good than harm, then it begs the question: if it is undermining our economy at the rate of $411 million per day, is it really the best place to spend American lives and treasure? Future estimates are not only controversial, they vary widely partly because the $12.5 billion a month that we’re now paying for Iraq is only a down payment—we’ll still be making disability payments to Iraq war veterans 50 years from now.
Although the sub-prime problems began to surface in 2007, they were being spawned as far back as 2003 up through early 2007 with the investment banks unloading as much paper as possible on the unwary. Yet, at the same time, Countrywide, Wachovia, Washington Mutual, Downey Savings and a host of other lenders, continued to write shaky alt-A and sub-prime loans, while Wall Street repackaged them and sold them to somebody.
But, if the U.S. wasn't buying most of the stuff, somebody else was. And, as we have seen, that somebody was foreign money. European banks, overseas insurance companies, foreign pension funds, and government funds (also known as sovereign wealth funds) “all drank the Kool-aid”. So what has started to unfold, it seems, is that the Bank of China, is going to have to write down an additional $300 billion in mortgage backed security exposure, above the amount that it has already reported as having written down. Like Yogi Berra’s statement “It ain’t over, till it’s over,” more write downs should be forthcoming, since no one knows how much bad paper was peddled around the world until the bottom fell out of the market in 2007.
Two key developments have become evident—one, is that the U.S. stock market has been impacted and the other is that all global stock markets, including China and the ECU, are now starting to fall in tandem. In fact, even as U.S. stock and housing markets seem to be trying to stabilize, foreign markets are starting to show significant weakness. The collapse of the housing bubble in the United States is migrating abroad, with real estate prices swooning from the Irish countryside and the Spanish coast to Baltic seaports and even parts of northern India and Australia. European banks have suffered worse losses on US property than American banks.
More tellingly is the fact that foreign currencies are also starting to fall, which is a sign that sellers are now starting to unload whatever they can, which is what is liquid. When liquid assets are being unloaded, despite what the fundamentals are suggesting, you've got something else going on. And that something else is a huge global margin call.
Since August last, lenders enacted various reforms to insure their survival: they tightened their guidelines considerably, mandating higher FICO scores and reserves, LTV & CLTV ratios were dropped 5-15%, low doc and no doc programs like No Ratios, NIVAs, NINAs disappeared from nearly every lender’s repertoire—as have 271 lenders (IndyMac, and Wachovia Bank the most recent and notable lenders to implode). Initially, hedge funds and other entities that were saddled with the sub-prime loans were forced to sell as were (ironically) many of the Wall Street investment houses that got stuck with their own bad paper that they could no longer peddle to foreign buyers.
The ratings agencies have been under fire ever since the credit crisis began to unfold, and new regulations may force them to distance themselves from the investment banks whose products they were paid to rate. Last year, Moody’s had to downgrade more than 5,000 mortgage securities—a tacit acknowledgment that the mortgage bubble was abetted by its overly generous ratings. Mortgage securities rated by Standard & Poors and Fitch have suffered a similar wave of downgrades. Moody’s, Standard & Poors, and Fitch are, at last, scrutinizing mortgage-backed securities ever so carefully.
Other than Bernanke, the only other person that has distinguished themselves in terms of leadership has been Barney Frank, the Chairman of the House Financial Services Committee. He has made several substantive proposals aimed at correcting some of the systemic financial abuses. Among the prescriptives he’s proposed: that mortgage originators—indeed, all lenders—should have to carry a portion of their loans on their books so that they would bear some risk if things went wrong, with the investment banks who securitize them also retaining a chunk, another is requiring investment banks to disclose off-balance-sheet risks while also making the firms subject to audits, much like commercial banks are now and that investment banks set aside reserves for potential losses to provide a greater cushion during financial panics. Mr. Frank also sees the need for stricter supervision over Wall Street investment banks, hedge funds and the fast-growing market in derivatives like credit default swaps which are supposed to insure lenders against loss but became a speculative instrument themselves and gave many institutions a false sense of security. These proposals will not immediately solve the housing crisis, but they go to the heart of the issue and should be given serious consideration.
As this is being written 7/30/08, the White House has reversed its long-standing threat to veto the mortgage relief bill that Congress passed last week. The legislation’s purpose is to offer affordable government-backed mortgages to homeowners at risk of foreclosure and provide aid to states to buy foreclosed properties. Unfortunately, this will not be the panacea that mortgagors in trouble hoped for. It applies to only owner occupied properties and loans that were issued between January 2005 and June 2007 and the amount of the new loan may be no more than 90 percent of what the property is currently worth, so lenders will be forced to take a 10% loss on the outstanding loan balance. Those who qualify for these HOPE loans will have to pay a 3% Mortgage Insurance Premium (MIP) plus a 1.5% MIP annual fee on the unpaid balance, paid in monthly installments. And then there’s the matter of equity sharing. Any appreciation on properties refinanced under it will be shared with Uncle Sam, anywhere from 50 to 100% will go the government. Homeowners may be current or in default, but either way borrowers must prove that they will not be able to keep paying their existing mortgage and attest that they are not deliberately defaulting just to obtain lower payments. Furthermore, before homeowners can get FHA-backed mortgages, they must first retire any other debt on the home, such as a home equity loan or line of credit and they must be spending at least 31% of their gross monthly income on mortgage debt to be eligible for the program. Controversy is now raging whether underwriting authority for refinancing troubled mortgages will be in place by the time the bill is supposed to go into effect on Oct. 1.
What we’re seeing is a recession that is different from other recessions. Normally, the economy goes bad first, creating financial problems but with the current situation the financial and credit markets are dragging the economy down, a crucial distinction because markets are harder to fix than the economy. The reason this crisis is different from previous ones is because two bubbles are deflating at once. There's the collapse of housing prices, of course. On top of that there's the end of credit expansion that has been going on for 25 years. This was made possible by a fairly stable global financial system in which the dollar was the world's de facto currency. Now, for several reasons, the system is in question and nothing has quite taken its place. That has created great uncertainty. Since the 1980s, the global financial system has been dominated by an ideology that markets are rational and self-correcting—the belief that regulation distorts free markets. But markets aren't perfect. Left to their own devices, they always go to extremes of either euphoria or despair. The Federal Reserve and other regulators should certainly acknowledge as much (and also address the twin issues of derivatives and credit default swaps) since they've had to bail out the capital and credit markets in crisis after crisis. The Fed's first duty is to prevent the financial system from collapsing. It's shown it can do that, and the markets are breathing a sigh of relief. But we can't avoid the fallout in the real economy. We're facing not only recession but also inflation and a flight from the dollar. To fight recession, the Fed has increased the money supply, but that only makes the dollar weaker and inflation worse.
The credit-financed consumer boom of recent years is coming to a painful end. As we saw last year, investors’ trust was betrayed which led to the credit crunch. Supposedly safe investments suddenly turned into junk bonds when the housing bubble burst and when investors found out they had been duped there occurred a crisis of confidence. As with nearly anything, it takes much less time to take something down than to restore it to working order. The restoration of confidence in the credit markets will take considerable time because as the saying goes: “Once burned, twice shy”.
The nightmare of imploding loans known as Option ARMs has yet to be dealt with and it will likely be the next wave that sends the credit markets reeling. (For more on this see the July issue (Vol. 5 issue 7) on TEASER RATE LOANS—THE NEXT FINANCIAL CRISIS). Some $500 billion is on track to implode in early 2009. Sixty percent of these mortgage loans are here in California, making the state a $300 billion time bomb. Overall, California’s housing market is down about 30 percent this past year. As we will see in the upcoming months these loans will prove to be a huge hit to the already imperiled California housing market. Today's American Way of Life has little chance of surviving the coming years unscathed.
Copyright © 2021 Rod Haase. All rights reserved.