THE S & L CRISIS

It’s time for a slight detour, which has some relation to the dismantling of
regulations, and that is the Savings and Loan crisis of the 1980s. First, a brief
history of S & Ls.
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“Thrifts” (which officially had their name changed to Savings & Loans in the late
1930s) were originally non-profit coops managed by their membership and local
institutions. Most often, they only made home loans, primarily to working class
men and women (differing from banks which had a wide array of products and
served both individuals and businesses). S&Ls had their origin in late 18th Century
England, with the British building society movement (aka Buildings & Loans).
The panic of 1893 caused a decline in membership. By the end of the 19th
Century, nearly all B&Ls were out of business. In 1934, the FDIC was extended to
S&Ls. Of note, all S&Ls were charged the same insurance premium regardless of
the richness of each S&L’s particular portfolio. S&Ls were resurrected over time
with a prominent rise in the two decades following WWII, as millions of
servicemen returned from overseas and started families. This new generation was
known as the “baby boomers,” and a surge in home construction resulted, fueling
the development of suburbs. By the 1960s, S&Ls experienced a strong expansion,
largely due to this construction surge.

An important trend emerged which was the raising of interest rates on savings
accounts to attract depositors. This led to rate wars between S&Ls and commercial
banks. Since 1933, the Federal Reserve had limited the interest rates that
commercial banks could pay on deposits (Regulation Q). These rate wars
prompted Congress in 1966 to set limits on savings rates for S&Ls and commercial
banks. S&Ls were hit especially hard in the 1970s during the stagflation period.
The bread and butter of S&Ls were short term deposits, but they were routinely
extending long term loans (fixed mortgages for 15, 20, 30 years). Because
depositors’ savings rates were now capped, when the cost of money would rise,
depositors removed their money and invested in accounts that had higher rates of
return such as money market accounts, CDs, etc. (This removal and reinvestment
process is referred to as “disintermediation”). The S&Ls often wound up paying
more out to depositors than they took in. Also higher interest rates meant home
loan qualifying became much more difficult since less people could afford homes.
These factors all limited S&Ls from making money. S&L managers responded by
offering interest on checking accounts, and alternative mortgage instruments. It’s
worth noting here that, before 1981, adjustable rate mortgages (ARMs) were
barred. Adjustable rate mortgages, also called variable rate mortgages, have their
interest rates periodically adjusted – usually linked to the cost of borrowing money
that the lender experiences within their credit markets.

In October of 1979, then Federal Reserve Chairman Paul Volcker restricted the
money supply. Short term interest rates skyrocketed. In the ten months from June
1979 to March 1980 interest rates rose more than 6% from 9.06% to 15.2%. In
1981 and 1982 combined, the S&L industry reported $9 billion in losses.

DEREGULATION

During 1980 and 1982, Congress passed two laws deregulating S&Ls. The
Depository Institution Deregulation Monetary Act of 1980 (in which the FDIC
limits were raised from $40k to $100k), and the Garn-St. Germain Depository
Institutions Act of 1982. The Legislation authorized the use of more lenient
accounting rules for financial reporting, and eliminated restrictions on the
minimum number of S&L shareholders. It also eliminated the deposit interest rate
ceilings mentioned earlier. These maneuvers, coupled with a decline in regulatory
oversight, were factors that led to the S&L collapse. The laws were intended to
help the S&Ls get back on track, but they were also significant because, for the
first time, the government sought to increase S&L profits rather than promote
home ownership. The legislation also resulted in more lending then was prudent,
especially in commercial real estate for which S&Ls were not experienced in
assessing risks.
In November of 1980, The Federal Home Loan Bank Board (the now defunct
regulator of S&Ls) removed the limits on amounts of brokered deposits an S&L
could hold. Brokered deposits allow brokers to pool depositors money and create
$100,000 instruments (the new FDIC limit). These instruments were placed, for a
specified period of time, with the S&Ls offering the highest return. Although the
S&L had use of those funds, brokered deposits actually helped keep insolvent
S&Ls liquid, delaying regulators from closing them.
In August of 1981, the U.S. Congress passed the Tax Reform Act of 1981.
Powerful tax incentives were created for real estate investment by individuals, and
a huge boom in real estate ensued.
In January of 1982, The Bank Board reduced the requirement that an insured S&L
had to have a net worth equal to or greater than 4% of its total deposits down to
3%. It had already been reduced from 5% to 4% just 14 months earlier. Moreover,
now that accounting reporting rules had been relaxed, it was much easier to reach
the 3% threshold.

Deregulation had given the S&Ls many of the capabilities of commercial banks
without the regulations of commercial banks (i.e., to make consumer loans, and
issue credit cards). S&Ls could elect to be under federal charter and thereby
deposits were insured against loss by the government. This encouraged S&Ls to
be more speculative. In December of 1982, in response to massive defections of
state chartered S&Ls to federally chartered S&Ls, California allowed its S&Ls to
invest in any venture without limitation. Texas and Florida followed suit.
By the end of the S&L crisis, 5% of S&Ls had invested in junk bonds. A bond is
basically a contract in which a corporation or government borrows money (aka
bond issuer) from an investor (bond holder) and pays interest at fixed intervals
(coupons) and repays the principal at a later date (maturity). The higher the credit
rating (basically the likelihood the principal and interest will be paid on time)
given to a bond by a credit rating agency, the safer the bond. Junk bonds are rated
below investment grade, and have high yields because they have a higher risk of
default.
From 1982-1985, The Bank Board reduced its regulatory staff starting salaries for
regulators. In 1983 the starting salary for an examiner was $14k a year and the
average examiner had two years of experience. During this period of oversight
retraction, S&L assets increased by 56%.

In 1983, The FHLBB eliminated the limits on loan to value ratios for S&Ls. They
were now free to loan up to 100% of the appraised value of a home.
In March of 1984, Bank giant, Empire Savings of Texas, fails. A pattern of
criminal activities is revealed. The failure cost taxpayers $300 million. In
reaction, the FHLBB begins reversing deregulation, by placing limits on S&Ls.
For example, direct investments by an S&L are limited to the greater of 10% of the
S&L’s assets or two times the S&L’s net worth-- so long as the regulatory
definition of required net worth is met.
In March of 1985, The governor of Ohio closes all S&Ls. Eventually S&Ls that
can qualify for FDIC insurance are allowed to re-open.
In May of 1985, S&L failures in Maryland, cost its taxpayers $185 million.
In the midst of the S&L collapse, The U.S. Congress passes the Tax Reform Act of
1986. This Act was significant in many ways: it lowered the top tax rate on
individuals from 50% to 28%, while raising the bottom bracket from 11% to 15%;
it increased the home mortgage interest deduction; it eliminated the interest
deduction on credit cards; it encouraged everyone with equity in their homes to
refinance which led to an explosion of second mortgages and its less stigmatic
cousin, the HELOC (Home Equity Line of Credit). Second mortgages and
HELOC’s were tantamount to using one’s home as an ATM. Also of great import,
TRA 1986 limited tax deductions on investor’s passive activity (losses and gains)
essentially eliminating tax shelters, especially for real estate (passive activity is
explained in greater detail later on). Prior to 1986, it was commonplace for
investors to pool money in syndicates, buying/developing both commercial and
residential properties and hiring companies to manage those properties. TRA 1986
also limited deductions of losses from investor gross income on losing properties.
This led to large-scale dumping of those properties, which torpedoed real estate
values.
In May of 1987, S&L accounting reporting standards were tightened. By the end
of 1987, the combined losses from Texas S&Ls alone exceeded half of all S&L
losses in America, and 70% of the twenty largest losses in the U.S. were in Texas.
And in February 1988, the FHLBB unveiled a plan to consolidate and package
insolvent Texas S&Ls, and sell them to the highest bidder-- 205 S&Ls were
disposed of with assets of $100 billion.
In August of 1989, FIRREA is passed by The U.S. Congress (Financial Institution
Reform Recovery and Enforcement Act). It abolished the FHLBB & the FSLIC
(Federal S&L Insurance Corporation). It also promulgated meaningful S&L
regulations, including satisfactory net worth requirements, as well as funding for
criminal prosecutions of S&L crimes by The Justice Department. A bureau of The
U.S. Treasury Department replaced the FHLBB & the FDIC replaced The FSLIC.
From 1986 – 1995, federally insured S&Ls declined in the U.S. by 50%, from
3234 to 1645.
By 2004, S&L bailouts had cost the U.S. taxpayers over $124 billion. By the end
of 2004, 886 S&Ls remained with assets of $1.35 trillion.
There were two other significant events that took place in the 1980s which are
worthy of mention:
First, October 19, 1987 – Aka “Black Monday” – the Dow Jones Industrial
Average fell almost 22% in a single day-- 508 points (The DIJA is a stock market
index tracking 30 large "blue chip" public companies performance during a
standard trading session). The sell off began in Hong Kong, then Europe, then
followed by the U.S. To this day, no one knows what triggered the sell off-- panic
for no apparent reason. Remember, the Kabbalist does not subscribe to the notion
of "suddenly." Somewhere there was a seed planted, and because of the disconnect
caused by time, space and motion, we can not see that this was a consequence of a
seed planted.
Second, November 9, 1989, the collapse of The U.S.S.R. As The Berlin Wall
comes down, capitalists worldwide are emboldened. They conclude that
communism is a failed system. By the way, and not insignificant the eighties are
dubbed “the me generation.” A whole generation named for acting for the self
alone!

HOME OWNERSHIP PUSH RENEWED

The 1990s are ushered in with a new technological explosion-- the internet and
dot.com craze, as well as a continued push for home ownership. In 1992, George
Bush, Sr. signs the Housing & Community Development Act to facilitate the
financing of affordable housing for low and moderate-income families.
In July of 1997, The U.S. Congress passes the Taxpayer Relief Act. The Act
encourages people to buy more expensive homes and second homes. It lowers the
Federal long term capital gains tax rate from 28% - 20%. Capital gains are profits
that result from investments like stocks, bonds, real estate, goodwill, etc., as
opposed to ordinary income such as salary. Profits or income can be either
"active" (you were actively engaged in generating that profit/income, usually with
20+ hours per week devoted to that generation) or "passive" (you benefitted
chiefly through the efforts of others). Long term capital gains are assets that are
held for at least one year. So ask yourself this question. If you are able to buy an
asset and hold it for a year, then sell it for a profit, why should that profit be taxed
at a lower rate than anyone’s salary for a year? At the risk of stating the obvious,
capital gains sources of income represent a large chunk of income for the wealthy.
Also under The Act, the first $250K ($500K for couples) of gain on a personal
residence sold is exempted, so long as it has been lived in for two years. In
addition, The Act raised the estate tax exemption from $600K to $1 million,
phased in over 10 years.
In September of 1999, Fannie Mae eased the credit requirements for the underlying
loans it bought from banks and other lenders. The goal, again, was to increase
home ownership among minorities and low-income consumers. The credit easing,
encouraged banks to extend mortgages to below credit-worthy people, who simply
could not qualify for conventional loans.
In November 1999, on the eve of the new millennium, The U.S. Congress passed
The Gramm-Leach-Bliley Act, repealing The Glass-Steagall Acts. It is signed into
law by then President Bill Clinton. It was passed under the theory that banks
should be able to diversify to be able to reduce their risk. The Act effectively
removed any distinction between Wall Street investment banks and ordinary
depository banks. In other words, banks that were insured by the FDIC could now
speculate with depositor's money. Case in point, banks were allowed to engage in
underwriting-- raising capital from investors on behalf of an issuer of securities.
The new millennium begins with the bursting of the dot com bubble in March,
2000.
Now it’s time to explore subprime loans and mortgage-backed securities, collateral
debt obligations, credit default swaps and Armageddon.

SUBPRIME MORTGAGES

From 1998-1999, subprime mortgages accounted for 5% of all mortgages. Within
ten years that number would hit 30%. So what exactly are subprime mortgages?
Very simply, subprime mortgages are loans to borrowers that don’t meet credit
worthiness standards, and thus have a greater likelihood of default. One rule of
thumb is subprime mortgages are loans made to borrowers with a FICO credit
score of less than 620. FICO (Fair Isaac Corporation, named after its two
founders) is a fairly simplistic measurement of credit worthiness. Over 90% of
SPMs were adjustable rate mortgages (ARMs) in 2006. By 2008, it was clear to
anyone who bothered to look, that nearly 1/3 of all mortgages had a reasonable
likelihood of default.
Another fact to keep in the back of your mind: In 1997, the average U.S. household
had a debt to disposable income ratio of 77% (disposable income is all of your
personal income less your personal taxes). So, on average, after paying taxes,
people borrowed 77 cents for every dollar they earned. That’s a pretty high
number. But by the end of 2007, people borrowed $1.27 for every dollar of
disposable income earned (most of that debt was mortgage-related).
Why take on so much debt? One reason is that, similar to the tulips in 1600s
Netherlands, pretty much everyone thought that the value of houses would never
go down. Moreover, the values would only go up! So if one got into trouble, they
could refinance – again, use their homes as an ATM. Another explanation for the
debt explosion, is that home ownership, for generations, has been and continues to
be pushed by the government and American culture. In one speech, George Bush,
Jr. actually said that "part of being a secure America is to encourage home
ownership." The company slogan of Ameriquest, one of the most fraudulent and
worst abusers of ethical lending practices, was "Proud Sponsor of the American
Dream." Why is home ownership the “American Dream”? Think of the home
mortgage interest tax deduction. You can’t deduct the rental expense on an
apartment, but home interest you can – why? The 30-year fixed mortgage is
standard in only the U.S. and Denmark. Fannie, Freddie and Ginnie Mae all allow
for government-insured mortgages, which helps keep mortgage interest rates low
and encourages home ownership. The last reason to mention regarding our
proclivity for taking on debt ... because it was there – credit was plentiful. For
years before the crisis hit, the world was awash with capital. Asia and the oilproducing
countries poured money into the U.S.. Interest rates were low, and
temptation was high.
The denial rate for a conventional home loan in 1997 was roughly 28%. Five years
later it was roughly 14%. Another telling statistic, according to a U.S. treasury
report: between 1997 – 2005 there was a 1400% increase in mortgage fraud
(essentially where one intentionally materially misrepresents or omits information
on a mortgage loan application such as altering W2s and other income
submissions, as well inflating appraisals, etc.). Much, if not most, of this fraud
was conducted at the behest of unscrupulous loan officers. In fact, in October of
2004, the assistant director of the criminal investigative unit of the FBI, Chris
Swecker, told Congress that "mortgage fraud is pervasive and growing."

STRUCTURED FINANCE INSTRUMENTS

Before we turn our attention to the global economic meltdown, we need to
examine the world of finance and financial instruments, specifically MBSs, CDOs
and CDSs (mortgage-backed securities, Collateral Debt Obligations and Credit
Default Swaps). Before all of these “innovations” there was the good ole world of
government bonds and corporate bonds.
A government bond is basically a promise by that government to pay a certain
amount (face value) by a certain date (maturity date) along with periodic interest
payments (usually in that country’s own currency). If it’s issued in a foreign
currency, it’s called a sovereign bond. The first Government bond was issued by
England in 1693 to raise money for a war against France. These bonds are
considered “risk free” since defaults by countries are rare-- Russia in 1998 and
Greece in 2011.
Corporate bonds are issued by a corporation to raise money. The maturity date is
generally greater than one year. Maturity dates of less than one year are sometimes
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referred to as “commercial paper.” The interest rate is often referred to as “The
Coupon.” Corporate bonds are frequently “listed” on stock exchanges. Corporate
bonds generally have a higher yield than government bonds because the risk of
default is higher.
So now comes the mortgage-backed security; MBS (aka, asset-backed securities –
ABS). These are bonds that are sold to investors who buy a portion of the stream
of income from a pool of thousands of home loans. A mortgage servicing
company collects the mortgage payments, subtracts their fee, and the remaining
principal and interest passes to investors.
By the way, Wall Street wasn’t the first to offer the MBS; it was the government.
As mentioned earlier, Fannie was split into two in 1968: Ginnie Mae was the
government arm and Fannie was half private, with shareholders and a board of
directors, and half G.S.E., while Freddie Mac was created to buy mortgages from
S&Ls and others.
Ginnie was the first to sell mortgage-backed securities in 1970-- bonds whereby an
investor could share in the income stream of hundreds of FHA and VA loans with
the principal and interest on the underlying mortgages guaranteed by the U.S.
government. In 1971, Freddie issued securities backed by conventional mortgages,
also guaranteeing the P&I. (Remember conventional loans were extended under
credit worthiness standards set by Fannie Mae). Attractive, risk-free securities.
Doesn’t sound bad, right? But they were fairly unpopular with investors. Why?
Because they weren’t truly risk-free to the investor-- the bondholder, because of
something known as “prepayment risk.” The mortgage owner (mortgagor) can
pre-pay the mortgage at any time. Why would a mortgagor pre-pay? The most
obvious reason, interest rates drop so the mortgagor wants to lower their payments
by refinancing. When that happens, the bondholders get cash, but they lose the
future interest payments. Now they are left with cash that is less valuable since
they have to invest that money garnering lower yields because interest rates in the
market are lower. The good fortune of the mortgagor is the bad fortune of the
bondholder. Because of prepayment risk, the investor doesn’t know how long an
investment will last; only that money will come back when it is least desirable.
This is where Wall Street came in to solve that issue and make MBSs more
attractive to investors.
Investment bankers, most notably, Lewis Ranieri, devised a product whereby the
pool of home loan payments were carved into pieces called “tranches,” which is
French for "slices." The buyer of the first tranch was like the owner of the ground
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floor of a building in a flood – that investor is stuck with the first wave of
prepayments BUT now gets paid a higher interest rate. The second tranch gets the
second wave of prepayments, but less of an interest rate. If there is a default or
foreclosure, the home is sold and the proceeds are divied up by the tranches. The
AAA tranch may get 100% of its investment back, but the AA may not (if the sales
price is less than the mortgage balance). Incidentally, this is one reason why it is
so difficult to renegotiate a mortgage if you are a homeowner-- the AAA tranch
holder may be OK with it, buy lower tranches may not since they will lose income.
By 1981, MBSs for single family homes grew to $350 billion. By the end of 2001
it reached $3.3 trillion. By 1983, the mortgage financing arm of Salomon Bros.
accounted for almost half of Salomon’s $415 million in profits.
Tranching wasn’t the only factor in the success of MBSs. Another vital part were
the rating agencies. Before MBSs, rating agencies such as Moody’s, Standard &
Poor’s and Fitch, built their business almost solely around corporate bonds. At
first, they resisted rating MBSs, but eventually came around. Soon after, this
“structured finance” became a key source of profit for them. A quick tutorial on
the ratings system: AAA, AAA-, AA, AA-, A, A-, BBB, and BBB- are all
"investment grade" ratings. The highest, AAA, is considered to be as safe as a
U.S. Treasury Bond, with almost no chance of default. Anything rated below
BBB- are considered "junk" and are deemed too risky to be purchased by pension
funds or other institutional investment investors that are legally bound to hold only
safe investments.
Remember the GSE guarantees on Fannie & Freddie mortgages meant that
investors were not bearing the risk of mortgage default– the government insured
those loans. For some investors, GSE-based paper was the only type of mortgages
investors were allowed to buy. For instance, many states had laws prohibiting
pension funds from buying “private” mortgage backed securities. States also had
“Blue Sky” laws designed to prevent fraud. They required Wall Street firms to
register with each of the fifty states to sell MBSs, and the firms had to repeat that
step with each new bond issued. However, MBSs issued by Fannie or Freddie
were exempt from blue sky laws because of the implicit government guarantee.
By mid-1983, the GSEs had issued $230 billion of MBSs while the private sector
had issued $10 billion.
Lewis Ranieri disapproved of the massive power of the GSEs. He wanted their
grip weakened, and being a strong “market” conservative – the market is always
right and self-correcting – he felt that the private sector should be able to issue
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MBSs without Fannie and Freddie. He had strong ties to the Reagan
administration, and, with Ranieri’s help, the administration drafted The Secondary
Mortgage Market Enhancement Act (SMMEA). (Direct loans are loans made
directly to a borrower, so they are considered primary loans. In contrast, MBSs
constitute a secondary mortgage market.)
The SMMEA exempted MBSs from blue sky laws. It also removed restrictions on
pension funds and insurance companies from investing in MBSs issued by Wall
Street, even when they lacked GSE guarantees. The law further provided that
MBSs had to have a high rating by a credit agency. That provision enshrined the
role of rating agencies in MBSs. While some expressed concern that the rating
agencies were given too much responsibility, supporters of the legislation
reassured Congress that investors wouldn’t rely solely on ratings to buy an MBS.
In the end, the fear of “turning the mortgage market of America into a total
government franchise,” which was pounded into Congress by Ranieri, was too
much for Congress to ignore. The law was signed in October of 1984.
An interesting postscript to the notion that investors wouldn't rely solely on ratings,
comes in a statement by The Office of the Comptroller of the Currency 13 years
later: "Ratings are important because investors generally accept ratings ... in lieu of
conducting a due diligence investigation of the underlying assets ..." Moreover,
the rating agencies had charts and studies indicating that they were accurate a high
percentage of the time. On closer inspection, that doesn't appear to be the case.
Here are some well known failures the ratings agencies missed: the near default of
New York City; the bankruptcy of Orange County CA; the collapse of the Russian
and Asian economies; the implosions of: Penn Central Transportation Company,
Long-Term Capital Management, WorldCom and Tyco. Even back during the
depression in 1929, 78% of municipal bonds rated AAA and AA defaulted.
Enron's debt wasn't downgraded until four days before they filed for bankruptcy
despite the rampant fraudulent practices of Enron being exposed two months prior!
In the summer of 2007, Moody's released a statement saying that "there are no
negative rating implications ... as a result of [the banks'] involvement in the
subprime sector." Yet 93% of the AAA rated subprime residential mortgagebacked
securities issued in 2006 and 91% of them issued in 2007 were
subsequently downgraded to junk status.
The horrifying truth, at least when it came to mortgage backed securities was that
the agencies themselves never really conducted any due diligence regarding the
underlying mortgages. Basically, they assumed that if housing declined it would
be a relatively modest decline. Also, they believed that the housing market was
regional, so any decline in value in one part of the U.S. was irrelevant regarding
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another part (this is known as correlation). Another ugly factor that effected the
ratings of MBSs was something known as "ratings shopping." Investors preferred
to have two agencies rate a deal, but didn't require all three to rate a deal. This
allowed bond issuers to play agencies off of each other. If an agency was rating a
bond lower than the issuer wanted, the issuer could threaten to switch to the other
agency which would supposedly be more favorable. So if issuers could "game the
system" through ratings shopping, then how could the market, unaware of the true
state of the underlying mortgages contained within an MBS, correct itself??? The
answer is ... it couldn't.
Before MBSs, historically less than 2% of people lost their homes to foreclosures.
Quite simply, before the advent of the MBS, lending institutions and the borrower
had the same interest—getting the mortgage paid. But once the lender sold the
mortgage to a third party investor (as became prevalent with the advent of the
MBS), they had no real interest in whether there was a default.
When it came to creating securities from traditional mortgages
("securitizing"),Wall Street bankers realized, by the late 1980s, that they could not
circumvent the GSEs and thereby keep all the profits for themselves. They would
have to find some other mortgage product to securitize, something that Fannie and
Freddie wouldn’t touch. Enter the subprime mortgage. The first subprime
mortgage backed security was sold in 1988, by Guardian S&L. By 1991, Guardian
had sold $2.7 billion worth of securities backed by questionable loans.
A quick recap of how we legally ushered in these crappy subprime mortgages:
Before 1980, the ability to charge high interest rates and fees to borrowers was not
possible. States had instituted "usury laws," capping the interest rates people could
legally charge. However, these usury laws were preempted by Federal law in
1980 with the passage of The Depository Institutions Deregulation and Monetary
Control Act (DIDMCA). Logically, usury laws discourage lenders from
extending risky loans since those lenders may not be able to charge a high enough
interest rate to justify that risk. In addition, the use of variable interest rates and
balloon payments became permissible in 1982 with the passage of The Alternative
Mortgage Transaction Parity Act (AMTPA). And, finally, the big dog-- The Tax
Reform Act of 1986, which eliminated the deduction of interest on consumer loans
(credit cards), but kept the interest deduction on mortgages for primary residences
and a second home. This made mortgage debt (even with high costs and fees)
cheaper than consumer debt for many homeowners.
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Now back to the evolution of the subprime mortgage (SPM). If you recall, rising
interest rates had decimated the S&Ls in the early eighties. That factor, along with
Fannie Mae being granted the right to buy conventional mortgages, actually aided
non-bank mortgage originators like Ameriquest, Household Finance and
Countrywide to not only grow, but to dominate the home lending business. By
1989, non-bank mortgage companies funded 19% of home loans in America. By
1993, that figure reached 52%.
By 1992, Countrywide grew to become the largest mortgage lender in the U.S., and
its co-founder, Angelo Mozillo, was dubiously listed by Time Magazine in its
issue: 25 People to blame for the financial crisis. In the early 1990s, interest rates
began to fall, which helped more people afford homes. Countrywide began
advertising a new technique to allow people to use their homes as equity to borrow
more money than their current home loan, and take out the excess cash – it was
called "refinancing." In 1992, refinancing accounted for 58% of Countrywide’s
business. In 1994, it was 75%. Another significant practice instituted by Mozillo
was employing independent brokers to make loans so as to grow quickly. With the
S&Ls closing down by the hundreds, Mozillo had a large, cheap pool of loan
officers who, once they sold a loan and got their fee, had no “skin in the game.”
By 1997, delinquent payments and defaulted loans exceeded “projected levels.”
Compounding the cost of unanticipated losses was the use of “Gains on Sales
Accounting.” It has been called the financial equivalent of “crack cocaine.” A bit
complicated, but in a nutshell, this accounting method allows companies to book as
profit, in the present, the expected future value of loans. Moreover, it allows for
the assumption that a loan will always be repaid, and not prematurely. Obviously,
those projections were used to lure investors. In 1998, the rash of defaults and
delinquencies began to affect MBS prices since investors finally became concerned
about the underlying assets contained within the bonds. This, coupled with an
Asian financial crisis in 1998, made the cost of borrowing money higher. MBSs
backed with subprime loans dropped almost 18% from 1998 to 1999, but recovered
again from 2000-2003. Many subprime loan originators failed or were acquired
during this downturn, so that by 2003, 90% of all subprime lending was done by
just 25 firms. The collapse of the subprime companies didn't have much effect on
the banking system or the housing market, and within a few years the SPM
business would be stronger than ever. What should have been a warning to
regulators was left unheeded, or in Kabbalistic terms-- uncorrected.
Why was Wall Street so eager to market these SPMBS? Larry Fink, who is
credited with devising “tranching” for MBSs, was once asked by Congress whether
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Wall Street would ever try to securitize risky mortgages. He responded, “I can’t
even fathom what kind of quality of mortgage that is, but if there is such an animal,
the marketplace may just price that security out.” Basically, investors would
require such a high return that the security would be unmarketable. Once again,
the mantras of the market conservative: “the market is always right,” and “markets
are self-correcting,” simply turned out to be plain wrong.
One of the stunning revelations of the global economic meltdown was the
admission of market purist, financial guru, and former Federal Reserve Chairman,
Alan Greenspan. Also on Time’s list of 25 people to blame for the financial crisis,
Greenspan, in October of 2008, testified before Congress saying: “I made a
mistake in presuming that the self-interest of organizations, specifically the banks,
is such that they were best capable of protecting shareholders and equity in the
firms. I discovered a flaw in the model that I perceived is the critical functioning
structure that defines how the world works.”
Ironically, it was the U.S. government that gave Wall Street a jump start to
securitize SPMs. In another of a string of unintended consequences, after the S&L
crisis, the government, through the Resolution Trust Corp., wound up with
hundreds of billions of dollars worth of assets from failed S&Ls that they wanted
to unload. The best way to get rid of them was to securitize them, then sell them to
investors. Since much of these assets were too risky for Fannie or Freddie
backing, all they needed was an AA or AAA rating and pension funds would buy
them. So Wall Street devised various techniques known as “credit enhancements”
to lessen the risk to investors: get insurance companies to insure some risk; put
extra mortgages in the pool to minimize risk; or have some investment banks issue
letters of credit to investors in the event cash flows from the MBS dipped below a
certain level. These enhancements convinced the rating agencies to issue AA and
AAA ratings. Wall Street was finally able to create a huge securitization business
that they could market without sharing a dime with Fannie and Freddie.
In the early 1990s, the number of Americans owning homes had dropped slightly
due to the S&L crisis– 1.5% from 1980 to 1991. This prompted Bill Clinton, in
1995, to announce his National Home Strategy. It’s stated goal; increase the
number of U.S. homeowners by 8 million by the year 2000. Similarly, George
Bush Jr. pushed for increased home ownership. An unintended consequence of
pushing this “American Dream” is that politicians and regulators don’t want to
crack down too hard on subprime lenders because that could interfere with their
ability to make loans to the very people the government is trying to “help.” In fact,
one reason why Fannie Mae reluctantly ventured into the subprime world (the
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GSEs entered that market late in the game-- circa 2005) was to meet increased
affordable housing goals instituted by the Bush administration. Another reason,
more compelling, was higher profit margins-- the yield for guaranteeing subprime
loans was greater than 30 year fixed mortgages. By the end of 2007, the GSEs
owned 23% of all the outstanding subprime mortgage backed securities and 58%
of all Alt-A mortgages (Alt-A are riskier than prime, but not as risky as subprime).
The sheer size of the GSEs’ purchases definitely help inflate the housing bubble.
As the authors of "All the Devils are Here" put it: "Without the GSEs' buying
power, the private market would never have been as big as it got. And without
Wall Street, there never would have been all those bad mortgages for the GSEs to
binge on"
By the middle of the nineties, SPMs are booming. Moreover, they got another
steroid injection by the Federal Reserve who raised interest rates in 1994. This
caused refinancing to plummet – some “Prime” lenders, saw their loan volume
decline by 50%. How did they respond? They wrote subprime loans. Wall Street
also jumped into the act, not only by issuing bonds backed by SPMs now featuring
“credit enhancements,” but by extending lines of credit known as Warehouse Lines
of Credit to subprime lenders. These lines of credit allowed the Lenders to make
more subprime loans. Warehouse lines were the primary funding mechanism for
subprime mortgage originators. Then Wall Street got even more juice by taking
those subprime companies public such as: The Money Store (1-800-LOAN-YES);
First Alliance; Aames; Cityscape Financial; and New Century. Remember, Gains
on Sale Accounting made these companies look really profitable, and thus more
attractive to investors!
From 1994 to 1999, the number of SPMs went from 138,000 to 856,000, and from
$35 billion to $160 billion. Nearly 13% of all mortgage originations were SPMs.
In 1999, home ownership hit a record of 66.8%, but 82% of all SPMs didn’t go
towards buying a new home. They actually went to refinancing existing homes,
and 60% of those borrowers pulled out the excess cash.
By the way, I don’t want to paint the picture that all subprime lending was
intentionally predatory. Some lenders, Angelo Mozillo for instance, really
believed they were helping lower-income people and minorities. In the end
though, they were loaning to many people who couldn’t afford to borrow. Also,
we can't let borrowers off the hook either. Many borrowers used loans with teaser
rates that were fixed, usually for two years before the floating interest rates would
rise, to buy houses to flip at a higher price before the rate hike.
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In 1998, a prominent hedge fund, Long-Term Capital Management went bankrupt.
LTCM was started 5 years earlier by ex-Salomon Brothers’ bond trader, John
Meriwether. Meriwether had resigned from Salomon Brothers in 1991 after being
embroiled in a Treasury securities trading scandal perpetrated by a subordinate.
The U.S. Government had to bail out LTCM, but many subprime lenders were
subsequently denied capital, and went bankrupt. By 2002 there were no public
subprime lending companies in the U.S.
Left standing, was a lending behemoth named Household Finance Corporation.
They were still loaning second mortgages at a good pace. They offered 15-year
fixed mortgages at 7%, but it basically had a fraudulent component that tied the
interest rate to a 30 year loan, so that the effective rate of interest was 12.5%, not
7%. By the end of 2002, HFC settled a class action suit paying a $484 million
settlement distributed between 12 states. The following year, HFC sold its
company along with their toxic subprime portfolio to HSBC, a British
conglomerate for $15.5 billion.
By 2005, SPMs were back in vogue. Why the resurgence? After the internet
bubble burst at the end of 1999, Alan Greenspan reacted by lowering interest rates
to near historic lows. Mortgage rates dropped substantially, fueling a demand for
home buying. At the same time, investors were seeking higher yielding
investments. Wall Street wanted the subprime mortgages to package into their
bonds, which were in demand because of the higher yield they offered investors in
that low yield market.
In the mid-nineties, $30 billion of SPM constituted a huge year. In 2000, there had
been $130 billion in subprime lending, of which $55 billion was repackaged into
mortgage backed securities (42.3%). By 2005, there were $625 billion in SPMs, of
which $507 billion became collateral for mortgage backed bonds (81%). The
underlying terms of SPMs had also changed over time. For instance, in 1996, 65%
of SPMs had been fixed rate loans. By 2007, 80% of SPMs were adjustable loans-
- usually fixed for the first two years. By 1999, more than 50% of all mortgages
had down payments of less than 10%. Countrywide even marketed a product
called an 80/20 loan, which were actually two loans meant to enable a buyer to
borrow 100% of the home's purchase price. In addition, Countrywide raised its
loan limit to $1 million in 2006, up from $400,000 in 2001. And again, most of
these subprime loans were for refinancing (2/3 in 2006), rather than for buying
actual homes. Moreover, roughly 60% of their adjustable loans were made to
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people who could not afford the increased interest rate once the teaser period
would expire.
Instead of trying to make loans to people who could afford to pay them back, the
goal was to make as many loans as possible and sell those loans as soon as possible
to Wall Street firms who would repackage them into bonds. Long Beach Savings
was the pioneer of the “originate + sell” strategy. LBS was the predecessor to
Ameriquest, founded by Roland Arnall. They were also the Originator of the
"stated income loan," which allowed potential borrowers to state their income
without any process of verification. In 2004, LBS loaned $50 billion worth of
SPMs (out of $587 billion total SPMs that year).
The quality of mortgages became less and less desirable over time. To wit: the
interest only negative amortizing adjustable rate subprime mortgage. There was
even an option for the home buyer to roll the interest only portion onto the
principal of the loan so the buyer would pay nothing for a period of time. Who
would be interested in that? A buyer with no income. Other toxic loans
developed such as: NINA loans, No Income No Assets-- "No problem"; and
NINJA loans, No Income No Job No Assets. Again, "no problem." All you
needed to borrow money was a good credit score.
So the lender was selling their crappy loans to Wall Street who packaged pools of
these crappy loans into MBSs and sold them to willing buyers all over the world,
in large part, because they had the AAA seal of approval from the rating agencies
and investors believed that real estate values would never decline.
Along with the MBS, Wall Street developed another related “structured finance
product” known as the CDO—Collateral Debt Obligation. It was first unveiled in
1987 by junk bond kings—Drexel Burnham Lambert. Once again, these pools of
obligations could be loans, pools of asset backed securities, or MBSs. So now you
have pools of subprime mortgages packaged into MBSs, and pieces of these MBSs
can be further packaged into yet another pool—the CDO. An amazing fact about
CDOs, investors frequently had no idea what securities were contained in a CDO
because securities were often changed, nor did investors seem to care. Again, they
were buying the AAA rating.
But that’s not all. Wall Street creates another revenue center, in the early nineties,
The Credit Default Swap, which they marketed as an insurance policy on MBSs or
corporate bonds. A CDS is a type, the most common type, of credit derivative.
Derivatives have been around for hundreds of years, and are a way to bet on the
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future value of something. Farmers routinely use them to safeguard against
fluctuations in crop prices. These derivatives sold on commodity exchanges along
with futures of fuels, precious metals, currencies, etc. A Credit derivative basically
transfers ("or swaps") the credit risk from the underlying loan to another party. By
way of example, let’s say a corporation offers, through an investment bank,
hundreds of millions of dollars in corporate bonds to buyers. A CDS buyer can go
out to a Swap Seller, and, in essence, make a bet that the corporation is going to
default within a specified time. The buyer makes periodic payments, say quarterly
or semi-annually, to the seller. For instance, $100,000 a year to buy a ten year
CDS against $50 million of that corporation’s bonds. The most the buyer can lose
is $1 million ($100,000 per year for ten years). If the corporation defaults, $50
million goes to the CDS buyer. The CDS actually originated at JP Morgan after
the Exxon Valdez oil spill in 1994. Exxon, JP Morgan's client, was faced with a $5
Billion fine and, to prepare, drew $4.8 Billion from its credit line with JP Morgan.
The investment return on the credit line was relatively minor for JP Morgan, and it
would have to tie up hundreds of millions of dollars of capital in reserve due to
their exposure. So they convinced the European Bank of Reconstruction and
Development in London to take a stream of payments in exchange for that bank
assuming the risk of Exxon's default on JP Morgan's credit line. The Euro Bank
felt relatively safe that Exxon, with $100 billion in 1994 revenues, would not
default and was happy to take JP's payments. Although the actual loan remained
on JP Morgan's books, they were happy to reduce their risk. The Exxon deal went
off without a hitch and ushered in the CDS era. Next, Wall Street would lobby for
"capital relief," meaning that if they bought credit protection through CDSs then
they should be able to hold less capital in reserve. In 1996, the Federal Reserve
agreed.
As I mentioned earlier, Wall Street "marketed" CDSs as a form of insurance.
However, a CDS is not true insurance and there are many distinctions between the
two. A CDS is more of a bet against the market. The buyer of a CDS does not
have to own the underlying security or debt obligation, in other words there may be
NO “insurable” interest. A “naked” CDS is when the buyer has no insurable
interest in the underlying asset. If the buyer has an interest in the underlying asset,
then the CDS is in essence a hedge or type of credit insurance. Moreover, the
seller of a CDS does not have to be regulated. And, of paramount importance, the
seller is not required to maintain any reserves to pay off buyers in the event of a
loss. Conversely, by law, insurance companies must hold a certain amount of cash
reserves to pay an insured in the event of a loss. Swap transactions can be done
entirely with borrowed money, and without any transparency or disclosure. In the
U.S., CDS contracts are generally subject to "mark-to-market" accounting which
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became a generally accepted accounting principle (GAAP) in the early nineties.
Mark-to-market accounting basically tracks the value of an asset daily, so that in
boom times an asset may be overvalued and in crises times the asset may be
undervalued. In contrast, historical cost accounting, used in insurance contracts, is
a simpler, more stable, principle based on past transactions. Mark-to-market
accounting can introduce volatility that would not be present in insurance
contracts.
In the late 1990's, JP Morgan developed a variation on the CDS. Instead of
referencing a single corporation such as Exxon, they would bundle hundreds of
credit derivatives on hundreds of corporations. They created CDOs containing
nothing but credit default swaps. While investors of MBSs owned pieces of actual
mortgages, here investors owned pieces of CDS "premiums," which were income
streams paid by the party insuring the risk. Because these securities were not built
out of "real assets" and had no collateral they were referred to as synthetic CDOs.
These synthetic CDOs made it possible to bet on the same bad mortgages dozens
of times. The Wall Street Journal uncovered a case in which a $38 million SPM
bond created in June 2006, wound up in over 30 debt pools and caused roughly
$280 million in losses!

ARMAGEDDON

In March of 2005, a brilliant investor with Asperger’s Syndrome, Mike Burry,
devised the idea to buy CDSs on SPMBSs. He figured that 75% of SPMs had two
year fixed teaser rates that would provoke thousands of defaults when the floating
interest rates kicked in. Remember, in 1996, 65% of SPMs were fixed rate as
opposed to the 80% that were ARMs by 2007. Burry eventually convinced some
Wall Street firms to underwrite CDSs on SPMBSs. Within three years, that
segment of business would become a trillion dollar business fueled, in large part,
by the rating agencies. Wall Street viewed the SPMBSs as safe, and were happy to
take Burry's money, as well as a few others who were jumping in to buy the swaps.
In fact, the swaps were so inexpensive to buy it is clear that Wall Street did not
understand the risk it was insuring. In May of 2006, Standard and Poor’s
announced plans to change the model used to rate SPM bonds, effective July 1,
2006. Immediately, the creation of SPM bonds shot up, presumably before tougher
standards were employed. Two years later, the top rating agencies testified before
congress that their ratings were merely “opinions” and were not intended to be
relied upon. Perhaps that’s why Fannie Mae and Freddie Mac both had AAA
ratings at the time the U.S. Government took them over, or why Lehman Brothers
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and AIG both had AA ratings within days of their bankruptcy and bailout. (In case
you’re wondering, the sarcasm is intentional.)
Back to the second quarter of 2005, credit card delinquencies reached an all time
high. So even though home prices were booming and mortgage prices low, people
were struggling to pay their bills.
In October of 2005, investment banks were calling Mike Burry to buy the CDSs he
held. Why would banks want to buy insurance on SPMs? Quite simply, because
SPMs were going bad at a fast pace. From about 2000 to 2006, people whose
homes rose in value between 1%-5% were four times more likely to default than
someone whose home rose 10%. Why? Because millions of people couldn’t pay
their mortgages if they couldn’t borrow more money. As previously mentioned,
many loans were made with teaser rates fixed for 2-3 years to people who would
not be able to pay the “go to” rate when the teaser period ended. They would have
to refinance and the bank would make more money. So bankers were selling
bonds containing pools of toxic loans to clients and at the same time buying
insurance on those bonds!
How could this happen? One reason, the bond market, unlike the stock market,
had no meaningful regulations. That was also a reason why so many derivatives,
such as CDSs, were derived from bonds. Proposals had circulated to regulate
derivatives and have them trade on commodities exchanges like other futures so a
public market would be created. Wall Street lobbied hard against those proposals,
and, with Alan Greenspan’s support, was able to quash the efforts to regulate.
If bankers were selling crappy SPM bonds AND insuring them through CDSs, then
who was selling the insurance to the bankers? One of the largest insurers was AIG
(American Insurance Group). But how could AIG, an insurance company sell
unregulated CDSs? They sold them through their separate subsidiary AIG
Financial Products, which was able to escape regulations since it was not an
insurance company. Now the question is why would they do that? They began by
insuring corporate loans against defaults that they believed to be an extremely
unlikely event. And in the beginning, during the late nineties, that was true. By
2001, $300 million a year, or 15%, of AIG’s profits came from selling CDSs.
Next, the banks that bought insurance for pools of corporate loans (like to General
Electric) now sought to buy insurance on other loan pools—student loans, auto
loans, credit card debt, etc. AIG figured that pools of these other loans, just like
pools of corporate loans, were unlikely to all go bad at once since they too were
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sufficiently diverse. The logical evolution from there? Insure pools of SPMs.
Afterall, isn’t a pool of SPMs from Nevada completely different from a pool of
SPMs in Florida? AIG believed so! By the end of 2004, AIG had gone from
insuring 2% of Wall Street’s SPMs to insuring 95% of them-- $50B worth of triple
B rated SPM bonds. By 2007, AIG had $78 billion tied up in mortgage-backed
securities. You would think that AIG would get a huge return for insuring such a
risk. However, they charged just over 1% a year for that insurance. An investor
could pay roughly $2.5 million a year to insure $20B!
It was Goldman Sachs that created the structured finance “piece de resistance”--
the synthetic subprime mortgage bond-backed collateralized debt obligation. The
security was so complex that neither investors nor the rating agencies truly
understood it. By now, hopefully a pattern regarding the creation of financial
products has become obvious. As time goes on, these products become more and
more complex-- the synthetic subprime mortgage bond-backed collateralized debt
obligation; the only name that could top that would be the
supercalifragilisticexpialidocious collateralized debt obligation! And this serves as
the perfect segway to our next Kabbalistic principle-- curtains. But first, we need
to introduce another Kabbalistic concept of the 1% reality versus the 99% reality,
and then we can tie in the principle of curtains.
Kabbalah talks of the 1% reality as the physical world, the world of our five
senses. What most of us would call “reality,” Kabbalah calls an “illusion,” and
only 1% of the universe. It is an illusion because this is the world in which we
spend most of our time chasing the physical, the tangible. This is the world of
instant gratification. The world of “I will believe it, when I see it.” One example
that Kabbalists use to illustrate this point is comparing a new born calf to a new
born human being. A calf is walking in a matter of hours, sometimes minutes from
birth. Whereas a human baby can take a year to learn to walk. A calf knows in an
hour or so how to find its mother's milk, while an infant would die if it wasn't fed
by its mother. If you relied solely upon what you could see (1% reality), which
being would you think is the more evolved species? Clearly, the calf, yet we know
that not to be the case. In contrast, is the 99% realm. The realm of the nonphysical
universe, the realm of lasting fulfillment. The 99% realm is the world that
we all can inhabit when we abide by the non-physical laws of the universe—not
acting for the self alone; using restriction; understanding that every action or
thought has consciousness and plants a seed, and we may not see the consequences
of our actions, either positive or negative, for years or even lifetimes. It is because
of curtains that we erect that we can't see the 99% world when we plant a seed.
Stated another way, since we live in the 1% we usually only see the effects of our
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actions, we don't see that we are the cause. Kabbalists like to illustrate this with
the metaphor of covering a lamp in a room with many layers of cloth. Eventually
the room becomes completely dark, but the lamp is still burning. Because of
curtains we believe in the "suddenly syndrome." Remember from earlier, i.e.,
“suddenly the bottom fell out of the market.” Again, there is no “suddenly”
according to Kabbalah. It's the curtains that prevent us from seeing the effects of
our actions at the time of our actions. The increasing complexity of financial
products such as the synthetic subprime mortgage bond-backed collateralized debt
obligation were curtains preventing investors from seeing the negative effects of
those products at the time they were being offered. Curtains on the part of the
bankers devising the products, as well as curtains on the part of the investor. Why
do we proceed down a path when we know it seems "to good to be true"? Why
engage in "wishful thinking" and other delusionary undertakings? Because we
erect curtains which facilitate the disconnect between time, space and motion.
Why do we partake in that endeavor? Most likely in order to "act for the self
alone." We will return to this concept again.
Now, let’s jump back into the world of collateralized debt obligations. With a cash
CDO, a legal entity buys, let’s say 100 different mortgage bonds (a pool of loans)
and carves them up into tranches to resell. Wall Street took the riskiest bonds,
pooled them together (they would have had a BBB rating) and convinced the rating
agency that they were a diversified portfolio, and that somehow 100 BBB rated
bonds pooled together would now become a diversified portfolio of assets and
garner a AAA rating. In fact, it's estimated that between 85-95% of BBB rated
tranches of MBSs were repackaged into CDOs. Moreover, it's a lot cheaper for
banks to buy BBB rated tranches and repackage them, then AAA rated tranches
and repackage those!
Rating agencies didn’t have a CDO formula to value the CDOs, so they relied upon
formulas provided by the firms that hired them. Wall Street paid the agencies
more fees with volume, as well as the level of rating. If the agencies didn’t rate
AAA, they weren’t paid. Miraculously, the agencies pronounced 80% of the new
CDOs AAA (Yes, the sarcasm is intentional again). By the way, what do you
think Wall Street did with the 20% of bonds left over that were still BBB? They
pooled them together, created a new CDO and now 80% of that new CDO was
AAA rated. By 2006, CDO issuers were the buyers of almost all of the riskiest
tranches of mortgage-backed securities, thereby propping up the housing market
and contributing to the bubble. Firms were willing to buy crappy subprime
securities knowing they could hedge their exposure with a synthetic CDO. And
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without the willing buyers, investment firms might not have bought crappy
mortgages to package.
So Goldman Sachs sold SPM bonds to their customers, and also bought credit
default swaps, which were bets against the SPM bonds they were selling.
Goldman even had language in the fine print of some of its swaps stating that
Goldman may have material, non-public information which it may not have
provided to those customers, or that Goldman may be in conflict with the interest
of the investors in the transaction, and further provided the ability to unwind a
trade after three years if it was unhappy with the results. The drive to bolster
profits through proprietary trading (trading for the firm’s own account), even at the
expense of their own clients, was now firmly ingrained in the corporate culture of
Wall Street firms, especially at Goldman. When a trader sold a derivative to an
unsophisticated client and extracted a massive fee, it was celebrated as “ripping
someone’s face off.” Thousands of those unsophisticated buyers were
municipalities, including the City of Birmingham in Alabama, which went
bankrupt from its investments in derivatives.
In mid 2005, the head of AIG Financial Products, Joseph Cassano, promoted a man
named Gene Park to be “ sales ambassador” to Wall Street bond traders.
Essentially, when a bond trader approached AIG to insure a billion dollar tranche
of bonds backed by consumer loans, the ambassador would say “great.” The only
difference between Gene Park and everyone else at AIG FP, was Park said, “Great,
I just want to examine the pile of bonds underlying loans first.” Park discovered
that 95% of the bonds were subprime and that AIG was exposed to $50 billion of
BBB rated SPM bonds, which were billed as AAA diversified holdings.
Cassano and Park met with all of the Wall Street firms to try to understand the
rationale of these deals. Basically, the firms all said the same thing: “Not once in
the last sixty years have real estate prices fallen nationally.” And, on average,
home prices had skyrocketed 60% between 2000 and 2005. Unconvinced by the
rationale, AIG stopped selling CDSs by the end of 2005.
It is ironic that in 2006, as loans were continuing to decline in quality, the cost of
buying CDSs actually dropped! So who took over selling CDSs when AIG
stopped? Deutsche Bank, the German based investment house. Why? There is
anecdotal evidence that the Germans not only believed the rating agencies, but
more importantly, did not think Americans would be so destructive with their own
market. On a side note, in May of 2010, Germany banned the trading of “naked”
CDSs (remember, when the buyer has no insurable interest in the underlying asset)
on European Government Bonds. The European Union followed suit in
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November, 2011. By the end of 2006, home prices fell nationally by 2%. By the
end of 2008, the average U.S. home price was 30% less than it had been 3 years
earlier.
Wall Street firms, like any manufacturer, want to buy their raw materials cheaply
(in this case, home loans, consumer loans, etc.), and sell the end product (ABSs or
mortgage-backed bonds) for as much as possible. How does Wall Street set the
price? The price is based on the ratings by the rating agencies. And how did the
agencies evaluate the products? Did they carefully examine the underlying
individual loans? They simply used information given to them from the Wall
Street firms – such as the average FICO score of the whole pool of loans. Firms
could mix credit worthy borrowers with lousy credit borrowers. By the way,
people with virtually no credit history, aka “thin file” applicants such as
immigrants who never defaulted because they never borrowed money – had good
FICO scores and helped raise the average of the FICO pool. Michael Lewis, in his
book, “The Big Short,” details how a Mexican strawberry picker in Bakersfield,
California, earned $14k a year, didn’t speak English and bought a house with
100% financing for $724,000.
Moreover, Wall Street firms paid less for pools of loans with high and low FICO
scores, then pools of loans containing the 615 average score needed for AAA
rating. Firms would seek out loan originators and pay them extra money for pools
of loans with “thin file” FICO scores. Each CDO contained pieces of a hundred
different mortgage bonds, which in turn held thousands of different loans. The
rating agencies didn’t even know what was in the CDOs.
There is a theory that the language contained in the thick financial prospectus used
to sell SPM bonds and CDSs was so complex because the lawyers drafting them
actually didn’t understand the instruments themselves. That's the ultimate
"curtain," the drafters confused themselves! However, what is clear is that some
Wall Street language, which WAS understood by its creators, was also
intentionally meant to confuse. For instance (more veils), a bond consisting solely
of SPMs was not called a SPM bond; it was called an Asset Backed Security. If an
“A” designation was the most credit worthy, what would they call a less credit
worthy instrument? It wasn’t “B,” it was “Alt-A.” Overpriced bonds were not
“expensive” they were “rich.” Subprime mortgages were "affordability products."
The floors or levels of SPM bonds were “tranches.” The riskier ground floor was
not the lower level or basement, it was the mezzanine, or "mezz" for short.
Subprime was referred to as mid prime. Again, the foregoing are more illustrations
of curtains erected which separate or disconnect cause from effect.
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From the end of 2005 to the middle of 2007, Wall Street firms created between
$200B-$400B of CDOs that were backed by SPM bonds. As mentioned earlier,
80% of these were AAA rated, so that means $160B-$320B were classified as risk
free and therefore didn’t have to be disclosed on the balance sheets of these firms.
Another risky Wall Street practice that went unnoticed, but is worthy of mention
here, was the extensive use of repurchase agreements, commonly referred to as the
"repo market." In 2007, the U.S. investment banks used the repo market to fund
nearly half of their assets. This market allows a firm to pledge assets (often longterm
illiquid assets) in exchange for short-term loans, often overnight. In essence,
a repo is similar to a secured loan, with the buyer/lender receiving collateral
(typically securities) to protect against the default of the seller/borrower. One
danger of this involves timing. If the seller defaults, the borrower now holds an
acquired asset that may have declined in value. Also, repo transactions are exempt
from bankruptcy proceedings so a lender could grab its collateral at any time. As
the bubble grew, firms used riskier assets to repo, including mortgage backed
securities. And, of course, the lender readily accepted these MBS as collateral
because they received a higher return than a safer asset such as treasury bonds.
Banking regulators ignored the accumulation of this risk, admitting that they relied
heavily on the risk representations of management. It has been said that bad
regulation is worse than no regulation because it creates the expectation of safety.
By the end of 2004, the repo market reached $5 trillion in the U.S.
In April 2007, some of the big Wall Street firms became nervous that their AAA
tranches were eroding due to increased mortgage defaults and foreclosures. They
devised a plan to buy mortgages from distressed homeowners, forgive the
indebtedness and thereby avoid foreclosure and save themselves billions of dollars
in potential losses. When a number of large investors who had shorted (bet
against) the AAA tranches learned of the plan, they were incensed. They stood to
make fortunes if enough homeowners defaulted, and they screamed market
manipulation. In the end, the plan to prevent foreclosures was abandoned. These
investors, acting for the self alone, helped "tank" the entire global economic
system! It would have been cheaper, and far better for the world, to negotiate
some type of settlement to pay those investors since they were able to be paid
subsequently only because the U.S. Government stepped in to save AIG and others
in order to insure AIG did not default on its obligations to pay CDS owners. More
on this shortly.
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By March of 2008, the stock market woke up and investors realized that Wall
Street firms had lost in the hundreds of billions of dollars. But which firms? Much
of these subprime CDOs were not disclosed.
Bear Stearns had sold $40 in CDSs, for every $1 of capital it had. If you’re
wondering how that could happen, here’s two facts to consider: CDSs were not
regulated by the government; and Wall Street, through the Securites and Exchance
Commission, lobbied Congress in 2004 to loosen limits on leverage to 33:1.
Leverage is the ratio of borrowed money to bank or equity money. The higher the
debt to equity ratio, the more money a financial firm will make in a rising market
since their revenues will rise, but their costs of borrowing are the same. That it is
why, according to one economist named Richard Posner, "the private sector can
not be expected to adopt measures, such as forbearing to engage in highly risky
lending, that might prevent a depression, and thus why preventing depressions has
to be a governmental responsibility." Simply stated, corporations are not selfregulating.
"Restriction" is antithetical to pure capitalism. Remember,
maximizing profits is intrinsic to capitalism; you can't blame the lion for eating the
antelope.

BAILOUTS

Eventually, JP Morgan (with a $30 billion cash infusion from the U.S.) bought
Bear Stearns for $2 a share plus the government’s guarantee on Bear’s toxic assets!
(This was later revised to $10 a share.) Then U.S. Secretary of the Treasury,
Henry (Hank) Paulson, warned Wall Street, that the Bear Stearns bailout was a one
time deal. The phrase “moral hazard” was bandied about. In essence, if Wall
Street knew they would always be bailed out for mistakes that were their fault,
what would prevent them from making those same mistakes again? Does that
sound familiar vis a vis Kabbalah? Moral hazzard basically says if you constantly
bail out people with no accountability on their part, it promotes, “bread of shame.”
Also, think of moral hazzard in relation to Tikkun. Remember, if we fail to
correct, we will be faced with additional obstacles to overcome in the future. And,
again, those obstacles are likely to increase in severity and frequency until we
correct.
Before we get back to the 2008, specifically the reaction to the meltdown, I would
like to quote a section from “The Big Short” by Michael Lewis. Pay close
attention, to the concepts of planting seeds, and “time, space and motion,”
discussed earlier.
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“What people did with it (money)
had consequences, but they were so
remote from the original action that
the mind never connected the one with
the other. The teaser-rate loans you
make to people who will never repay
them will go bad not immediately but
in two years, when interest rates rise.
The various bonds you make from
those loans will go bad not as the loans
go bad but months later, after a lot of
tedious foreclosures and bankruptcies
and forced sales. The various CDOs
you make from the bonds will go bad
not right then but after some trustee
sorts out whether there will ever be
enough cash to pay them off.
Whereupon the end owner of the CDO
receives a note … We regret to inform
you that your bond no longer exits.”
Here are some more additional examples of planting seeds, and their
consequences:
In 1981, The CEO of Salomon Brothers, John Gutfreund, took that company
public. It was the first private partnership on Wall Street to go public. Next, they
leveraged their balance sheet, using investor’s money for all sorts of risky
investments. It’s fairly doubtful that they would do that if only the partners owned
the company. It’s also doubtful that they would leverage the company with $35 of
debt for every $1 of capital, or hold $50 billion in crappy CDOs, then sell them to
their customers. But in 1981, Gutfreund knew he could make a fortune going
public and the other firms followed.
The Mezzanine CDO, invented in 1987 by Drexel Burnham’s junk bond
department, took 20 years to help take down the world economy.
The first mortgage backed CDO was created by Credit Suisse in 2000. Within a
few years, CDOs were marketed that were filled with thousands of toxic subprime
mortgages like ticking time bombs.
Also in 2000, The U.S. Congress passed The Commodities Futures Modernization
Act, banning the regulation of derivatives (basically the CDS). Moreover, there
are numerous examples of state and local governments passing laws to combat
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predatory lending and other abusive lending practices only to see those laws
consistently stuck down by courts, legislatures and federal preemption all
orchestrated by lending industry lobbyists. In fact, according to the Wall Street
Journal, from 2002-2006, Countrywide spent $8.7 million lobbying to defeat antipredatory
lending legislation, while Ameriquest and it's executives spend $20.5
million!
By 2008, every CEO of the major Wall Street firms either led their companies into
bankruptcy or was bailed out by the U.S. Government. So, if the market is always
right, then all those CEOs went bankrupt as well, and wound up penniless, correct?
Unless you’ve been living in a cave for the past four years, you know that those
CEOs kept tens, if not hundreds, of millions of dollars. Some lost their jobs, but
many stayed on to help resolve the financial crisis they had either facilitated or
failed to foresee.
By September of 2008, Hank Paulson, a “market conservative,” had to adopt a
different philosophy – he pleaded and persuaded Congress to spend $700 billion to
buy the SPM assets from the banks. This was known as TARP, The Troubled
Asset Relief Program. The $13 billion AIG owed to Goldman Sachs to cover its
CDS liabilities was paid off 100% by the U.S. Government. Citigroup received
$25 billion and weeks later "went back to daddy" for another $20 billion, as well as
secured a $306 billion U.S. Government guarantee on Citigroup assets. In return,
the U.S. got shares of preferred stock in those banks. Preferred stock is a class of
ownership in a corporation that has priority over common stock for the assets and
earnings of the corporation. Technically, the U.S.' shares are equity for the
taxpayers, but there's no maturity date on that money to return, so it's a safe
addition to capital for those TARP recipients. Did the government extract anything
else? Changes to the existing management? Changes in the compensation
packages for the CEOs? An agreement to accept new regulations? Directives on
what to do with the funds, i.e. start lending again? Nothing of the sort! While the
capital infusion was not a gift, it certainly didn't have significant “strings attached.”
In fact, shortly after the TARP passage by Congress, Wall Street announced
billions of dollars of bonuses to banking executives. The public was virtually
apoplectic over the granting of bonuses, after the banks were bailed out with
taxpayer dollars, to the very people at the heart of the crisis. In March of 2009,
President Obama summoned 13 Wall Street executives to the White House, telling
them that he was the only thing "between them and the pitchforks." But, in a
stunning failure on Obama's part, no demands were made upon the bankers in that
room who had already received over $180 billion of bailouts. No accountability,
and no correction.
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By bailing out firms deemed "too big to fail," we create an incentive for
corporations to be gigantic and also promote financial irresponsibility. Before the
crisis in 2008, the 5 largest U.S. banks controlled roughly $5.1 trillion of assets.
Today they control roughly $8.5 trillion worth of assets, and control 52% of the
financial industry's assets--up from 17% in 1970. Those same banks also control
56% of U.S. GDP (up from 43% before the crisis). If we were worried before
about systemic financial failure because the banks were too big to fail, they're far
bigger and fewer now. By the beginning of 2009, the Federal Reserve began
buying SPM bonds directly from the banks because the $700 billion TARP was
insufficient. The risk of loss on $1 trillion worth of crappy and reckless
investments was passed from Wall Street to the U.S. taxpayer.
This is not to say the bailouts per se were bad or unnecessary. But when you
understand the concept of bread of shame, (the feeling of discontent that
accompanies unearned good fortune) perhaps this life saving infusion of capital to
failing banks without real strings attached helps us understand how these
remaining banks now fight tooth and nail to prevent Congress from instituting any
meaningful financial reforms or regulations. This is also not to create the
impression that regulations are a panacea. Moreover, regulations without teeth,
without meaningful enforcement by a competent staff are feckless. Case in point,
days before Bear Stearns failed, then SEC Chairman, Christopher Cox,
pronounced: we have a good deal of comfort about the capital cushions at these
firms at the moment."
Between 1998 and 2006, roughly 1.4 million first time home buyers obtained
subprime loans; that translates to roughly 9% of all subprime borrowers. The other
91% of subprime loans went to refinancings and second home purchases. By the
second quarter of 2010, the homeownership rate had fallen to 66.9%, right back to
where it was before the housing bubble. All that pain and suffering and no net
homeownership gains!
In 2010, President Obama signed the Dodd/Frank Wall Street Reform and
Consumer Protection Act as a reaction to the financial crisis. Many believe it is
“Glass-Steagall light,” yet one of the political parties (Hint: It begins with an "R")
is constantly trying to defund it, delay its enactment, or repeal it outright. And, as
mentioned above, Wall Street is lobbying hard to obliterate Dodd/Frank.
Perhaps this is a good segway to discuss the influence of lobbyists. During the S &
L scandal of the 1980s, at a congressional hearing, Charles Keating, the notorious
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banker who was convicted of fraud, was asked if his $1.5 million worth of
contributions to a few politicians could actually buy influence. He answered, “I
certainly hope so.” The financial services sector employs over 3,000 lobbyists;
that’s five per each member of Congress. From 1996 to 2006, Fannie and Freddie
alone spent $170 million lobbying Congress. Since passage of Dodd/Frank, the
banking industry has spent over $320 million lobbying lawmakers to weaken or
repeal regulations. The Dodd/Frank provision known as the “Volcker Rule,”
named after former Federal Reserve Chairman, Paul Volcker, would force Wall
Street to choose between traditional customer banking and proprietary trading—a
cornerstone of the Glass-Steagall Acts. The Volcker Rule was originally ten
pages, but since lobbyists have picked away at the bill, it now has over 300 pages
of loopholes and exemptions, effectively removing any regulatory teeth. Now,
influence peddling has the legal stamp of approval with the 2010 Citizens United
decision by the U.S. Supreme Court. That decision reversed one hundred years of
precedent, by equating political contributions to free speech and thereby allowing
corporations and wealthy individuals to buy government without transparency, and
paving the way for the political phenomenon-- the “SuperPac.” In fact, one month
before the 2012 presidential election, a total of 57% of all SuperPac dollars
contributed to the campaigns had been made by just 47 people!