“The tree of capitalism must be refreshed from time to time with the
blood of investors and bankers.” — Angry Political Optimist

 

James Burke once wrote, in an essay entitled “Fit to Rule”, that the modern world was connected to root events having to do with Linnaeus. His penchant to catalog and organize nature led to Darwin’s Galapagos trip; and from that Karl Mark derived his economic theories giving rise to Communism. Nietzsche’s interpretation, itself misinterpreted, philosophically enabled Nazism and Hitler and the “manifest destiny” derivative in the hands of J. P. Morgan and Getty gave rise to capitalism. Finding root causes is always an interesting journey. So when one looks around today, especially with politicians eager to cast the blame on others, it’s good to try and establish what exactly the root cause of the current fiscal mess might, in fact, be.

The story begins in 1933 at the end of the Great Depression with the passing of the Glass-Steagall Act by Congress (F.D. Roosevelt administration) which prohibited banks from selling investments and created firewalls between investment banking, commercial banking and insurance. Soon after, in order to resolve the mismatch in maturities in loans, and because banks couldn’t loan enough to support the post WWII baby boom, the Federal National Mortgage Association or “Fannie Mae” was created as part of the New Deal in 1938 (FDR administration) to provide a secondary market for mortgages. This organization purchased loans from banks which then allowed them to continue to service and lend. And all was good — the greatest generation prospered.

For thirty years, FNMA had a near monopoly on the secondary market, then, in 1968, FNMA was privatized by L.B Johnson because of Vietnam War fiscal pressure. Now, as a private entity, FNMA could generate profits, yet FNMA still obtained special treatment under regulatory and tax laws. As a consequence of this, investors perceived minimal risk in the company. In 1970, the Federal Home Loan Mortgage Corporation (FHLMC) or Freddie Mac, was created under the Emergency Home Finance Act. The FHLMC purchased mortgages on the secondary market, aggregated, tranched, and sold them as asset backed securities (ABS). Between them, FNMA and FHLMC was estimated to hold approximately 90% of all US mortgages accounting for 46% of the national debt.

Then Congress exempted FNMA and FHLMC from the FDIC Bank Holding Company Act capital/asset ratio reserve limit of 3%. Fannie and Freddie were free to leverage their assets. In 1999, the Graham-Leech-Bliley Act, supported by Robert Rubin (Clinton-Administration) repealed the 1933 Glass-Steagall Act and allowed banks to invest in securities, offer securities, and a cafeteria of financial services. This provided an immediate market for FNMA stock, especially as these shares were considered low risk investments and were returning high returns on investment. The 1995 interpretive letter approving low income mortgage securities as viable investments under the 1977 Community Reinvestment Act (12 CFR parts 25, 228, 345, and 563e) provided another market for FNMA. Commercial banks could now invest CRA dollars in FNMA legally. In 1992 Congress (H.W. Bush administration) mandated (GAO report number GAO-04-269T) that Fannie and Freddie increase their purchases of mortgages for low-income and medium-income borrowers and specified that approval metrics such as the ratio test should henceforth include unemployment and welfare payments as sources of income. HUD (Clinton administration) established ‘quotas’ for FNMA and FHLMC to insure 50% of all their loans be to minorities by 2001. Since FNMA and FHLMC are secondary markets, they pressured originating banks to offer more minority loans.

(The story accelerates to Internet time.) FHA regulations are written with loopholes that allows 0% down-payment mortgages. Down payment assistance market develops to exploit the loophole. The Zero Down Payment Act of 2004, introduced by Rep. Pat Tiberi (R-OH) (G.W. Bush administration), requires the Federal Housing Administration (FHA) to offer federally insured mortgage loans to certain eligible households to buy a house without a down payment. In 2005, FNMA revises its loan approval criteria to support post hurricane rebuilding.

The Rating Reform Act of 2006 passes into Law requiring the use of “Nationally Recognized Statistical Rating Organizations” or “NRSROs”. As a result, internal credit analysis at investment banks deteriorate. In 2007, FASB 157 is imposed on corporations requiring that assets be marked to market. Also in 2007, the Office of Federal Housing Enterprise Oversight (OFHEO) increased the FNMA conforming loan limit upwards to $729,750. This increase in allowed principle increased profit for FNMA. All these regulations and acts let FNMA and FHLMC offer securities at net interest margins that were extremely profitable. FHA mortgages with 0% down make it impossible for banks to compete. Banks have to match terms in order to compete. Financial houses have to develop new instruments in secondary markets to compete with FNMA and FHLMC.

At this point the dominoes are all aligned and ready to go. Backtrack in time slightly and pick up a second parallel thread. Two events occur: investors realize that a few lines of software, a pretty business plan, and a catchy name do not a market make; and two planes make unauthorized landings into downtown Manhattan. The 1-2 punch of the Internet bubble bursting and 9/11 sends the economy into a recession. The Federal Open Market Committee (“Fed”) ratchets interest rates lower and makes a horrible mistake, leaving them low for far too long. Liquidity is generated with nowhere to go since money markets and deposits are generating low returns. Well, there is always real estate.

Quants on Wall Street create new classes of securities to access this liquidity — Collateralized Mortgage Obligations (CMOs) and Structured Investment Vehicles (SIVs). Quants are not stupid and know that these are risky, so they create credit default swaps (CDSs) to cover and distribute the risk. Markets develop to trade these instruments. Purchases go global. Trillions of dollars are traded in these vehicles.

With easy money and low interest loans, more houses are constructed, exceeding the number of available buyers, even at 0% down. The value of real estate drops on market fundamentals (law of supply and demand). The underlying value of mortgages drop. Loans are valued at more than the house or real estate they are collateralized with. Because many houses were purchased on speculation, and the dollars invested are essentially zero, owners walk way leaving banks with securitized assets that are non-producing. The primary cascade starts.

As underlying values tank, derivatives such as CMOs and SIVs collapse and swap liabilities under CDS’s increase. FASB 157 requires assets to be marked to market and assets are devalued accordingly. As assets are devalued, new capital to make up the difference is required. However, the complex interconnection of derivatives and new investment vehicles do not provide mechanisms to evaluate risk. Few are willing to invest without an understanding of the risk involved. Bank and investment company outlooks become speculative and their stock prices reflect this. Rating agencies downgrade the companies. This triggers additional capital requirements written into the CDS contracts. The cascade increases. FASB 157 becomes virtually impossible to implement since there effectively is no market. Liquidity stops because 1) banks can’t value what they own; and 2) they don’t loan assets they have because they might need them for capital.

People don’t understand because political parties are off blaming each other. News commentators spew gloom and doom scenarios. Runs on money markets ensue. Money markets sell short term securities to cover withdrawals and the market for commercial paper, which is funded through the money markets, dries up. Liquidity in commercial loans drops. Companies cannot access their lines of credit by commercial paper (bonds, etc,) Companies have to restrict operations and downsize.

People without jobs cannot pay mortgages. Second stage of cascade begins. Consumers look at institutions and decide that their money isn’t safe. They withdraw funds — banks become insolvent and are seized by the FDIC. Other banks stocks fall as result. Confidence erodes further.


 

So if we look at the root cause of all this, while Wall Street has it’s share of responsibility, you don’t discipline a dog for urinating on a fire hydrant — he’s just being a dog. Similarly, investment bankers do what they do — borrow and lend money and attempt to make markets. In this case, the road to hell is paved with good intentions and shares of Fannie Mae stock.

When you receive your brand new credit card in the mail, you also receive a sheet with the terms and conditions of the arrangement you have established with the issuing bank. These terms govern how the bank views and manages its relationship with you. Typically these terms and conditions are variable in the sense that the issuing bank can revise and modify the terms without regard for you, the consumer. It’s a contract with you where you don’t have the benefit of legal representation, or even a voice in the process. Moreover, these term sheets tend to be very fine print, dense and written with a lawyer’s attention to comma placement and nuances the average reader would overlook. The last one I reviewed was about eight pages of 6 point type (Except of course for the Schumer box.)

What happens is, of course, that the consumer never reads the fine print. They read the box and the APR, but typically gloss over the billing cycle period, the ‘adjustments’ to the interest rate as a function of your payment behavior, grace period exceptions to cash advances, cash advance fees, late fee charges, overlimit fee charges, and the like.

Apparently financial institutions pull the same tricks with each other although I suspect that the fine print extends to 50 or so pages. Take, for example, a collateralized mortgage obligation (CMO) where the servicing agreement permits the servicer (the organization which actually accepts your mortgage payments and sends you notices, etc.) to advance payments on behalf of defaulted homeowners (essentially additional loans at 12% or more interest). These ‘servicer advances‘ go back into the trust and terms may be written so that these funds go to the junior security holders. That is to say the mezzanine tranche or lower quality segments of the portfolio.

For those unfamiliar with how asset-backed securities are offered, there are usually three segments or tranches: the senior or low risk, the middle or mezzanine, and the retained or equity tranche which is usually high risk. The equity and mezzanine tranches are subordinated to the senior tranche in that all senior obligations are paid out prior to any payment to the other tranches.

In the event of a foreclosure, the servicer advance funds are paid out first to these junior securities, even before the holders of the senior AAA rated securities receive any payment. Consequently, the foreclosed home sale may produce no proceeds to the AAA holder and may in fact generate a liability. If the servicer owns the junior security, then there is no incentive whatsoever to resolve defaults. The subordination of senior debt to the servicer advances makes the AAA rating of these senior securities a myth.

Additionally, terms in some securities permit borrowers to sell collateral and reinvest the proceeds in other assets, including ‘junk’ bonds. Most permit unlimited amounts of swaps obligations with debt that is senior to or equal to the original priority of repayment. Because the terms do not specify an acceptable risk level for these assets, the collateral backing the debt is compromised. Thus an AAA rating is meaningless — by the time the swap obligations are satisfied, or if the repurchased asset becomes valueless, nothing is left to payout the original debt.

So given the complexity of these arrangements, traders who participate in these markets are likely to look at a security and view its price, its predicted paper return and its rating and leave it at that. No one reads into the fine print, and even if they do, they are faced with much the same choice as the credit card consumer. The security is written and offered as-is. Optimistic traders (especially ones who never have experienced a down market) purchase the security confident in its value, until that is, the underlying asset defaults and sets off a chain of events which leaves the ‘investment grade security’ well below grade. These traders are like consumers who run up credit card debt trusting in low rates and generous payment terms, and who miss a payment, and subsequently find that a great deal becomes a terrible deal with little or no warning.

And now we have a liquidity crisis. No one wants to borrow or loan against securities that have been found out to be riddled with loopholes. While politicians wring their hands in anguish over the poor defaulted homeowner, the real Aegean stable is the financial industry. Until the term sheets are rationalized and simplified to the point where a trader knows his asset’s value, the confusion and resultant liquidity lock will remain. Alt-A packages are likely engineered in the same manner and they haven’t been touched yet. Look for another round of grief as these securities are reassessed.