Thursday, October 30, 2008

Why Homeowner Mortgage Relief Ain't Going to be Easy

Like many others, I was rather shocked last month on hearing about the need for a $700 billion bailout of Wall Street. The early storyline was that financial firms were saddled with too many securities backed by distressed U.S. home mortgages and, in a climate of fear and panic, they couldn't sell them at fair value. So that meant the government would have to step forward and act as a buyer.

Setting aside the fact that this narrative was disingenuous at best, dishonest at worst (the assets are most likely cheap because -- surprise -- they're simply not worth that much), I found the approach bass ackwards. It seemed more efficient to work from the ground up. Namely, if the securities were hard to value because of uncertainty over the mortgages they held, why not provide a structure for homeowners and lenders to rework troubled mortgages? In this “trickle up” approach, the securities would gradually become more stable and thus easier to trade. It seemed like a pretty good idea.

I soon discovered a huge, gaping flaw: your 2005 mortgage probably isn't held by your friendly neighborhood bank. Rather, it was sold off by the mortgage originator (maybe your bank, maybe a mortgage company) and the payment stream was repackaged as part of a security. In fact, your mortgage payments may even have been sliced into pieces and spread across 10 or even 50 different securities.

Now here's where the headache begins. Once you begin modifying mortgages on a large scale, you create all sorts of havoc. An investor who bought a mortgage-backed security under one set of rules and understandings, now is operating under a different one. Some investors will win, others will lose -- and this being America, the losers will likely litigate. That's why the managers of the pools of loans, the so-called “master servicers,” probably won't renegotiate them. It's a real mess that can only be circumvented by some kind of federal law, and even then at a potentially dangerous precedent of rewriting contracts.

This New York Times op-ed piece captures the predicament about as well and lucidly as any I have read so far and proposes a solution. But don't be fooled: any solution is going to be very tricky to execute.

Sunday, October 26, 2008

The Danger of Clinging to Myths of Security

In my fairly voracious reading on the current financial mess, I've yet to see anyone tackle in thematic fashion the idea of “myths of security.” I think this is a highly relevant subject (a tad philosophical, but not too much heavy lifting I promise), as it helps explain why an asset bubble can become grossly inflated. Security is, after all, the comforting touchstone to reality we seek when we’re faced with counterintuitive evidence, such as home prices surging 20 percent a year.

So what myths of security allowed the housing market to soar so high? By myths of security, I refer to a false sense of safety or comfort. These myths create what might be called a “security premium” in prices of assets, such as homes. In other words, investors are willing to shell out more money for assets perceived as safe and reliable.

A quick detour: Why is this last sentence true in general? 1. The pool of investors, and thus the overall demand, grows larger for safe investments. Example: pension funds were enticed to buy mortgage-backed securities because of the glowing credit ratings on the products. 2. Investors want compensation to assume risk. If you offer to sell an IOU for $1,000, payable in one year, you may get $995 if you're a moral, upstanding citizen with a good job. But if you're Sam Shady, an out-of-work transient, that IOU may fetch only $800, $700 or even less.

(There is an interesting corollary of all this that I'll skip over here, but it goes like this: if you appear to wave a magic wand and create a secure investment with a return of say 8% when other similar-yielding investments are much riskier, you start to suck money away from those others. This can further pump a bubble. In fact, the myths of security play into a vicious feedback loop: money is diverted to investments that, at a given yield, are seen as “safer”; these assets then spiral higher, drawing in more money.)

Here are four chief “myths of security” in the housing and financial mess:

Housing prices never fall.
This myth was fairly widespread. I remember hearing it from a good friend in late 2005, while living in South Florida. At the time, home prices inexorably climbed every month; flippers and speculators were running rampant, snatching up unbuilt condos and queuing up overnight to be first in line for sales in new developments. The reasons for the myth are easy to understand: houses are real, tangible, critical assets. Everyone needs shelter. But even the most indispensable assets can become significantly overvalued.

The Federal Reserve under Greenspan would intervene to prop up falling prices of major assets, such as homes.
This myth is key because it was on Greenspan's watch that home prices had such a huge run-up. That rise in value benefited from a phenomenon known as “the Greenspan put.” “Put” in this context is a high-finance term. It refers to a product that protects an investor from losing money on an asset. Believers in the Greenspan put thought that, should home prices start to fall, the Fed chairman would step in and pump money into the markets to support prices.

Good ratings from respected agencies such as S&P and Moody's made mortgage-backed securities safe to buy.
The market for bonds backed by shaky U.S. home loans could never have grown so huge had they not received such high safety ratings from S&P and Moody's and Fitch. Now we find that the raters were mostly trying to win customers and boost revenue. They weren't that careful or rigorous in their evaluations. The cynic’s view is that their ratings became the best that money could buy, so to speak.

Even if you weren't confident of the ratings on mortgage-backed securities, you could buy insurance on the investments to hedge against a drop in value.
Insurance-like products called credit default swaps were supposed to provide this extra layer of protection. The trouble is, the credit default swap market became huge and is opaque and unregulated. It's not clear how many “insurers” actually have enough money to make good on future losses on mortgage-backed securities. Many of the insurers were hedge funds, an industry on the ropes amid the current market turmoil.

What happens when you inflate a bubble on four big “myths of security”? Once these myths are exposed, the bubble deflates quickly and violently, it would seem from what we are now seeing.

Thursday, October 23, 2008

Shakespeare and the Credit Rating Agencies

The current crisis in the financial markets is being portrayed as, above all, a failure of trust. Banks are seeking unreasonably high rates to lend to each other because they don't know who is hiding skeletons in the closet and may be teetering on the brink of insolvency. But if you really want to understand the concept of trust squandered, you would do well to look at the plight of the credit rating agencies.

These companies slapped attractive ratings on dubious mortgage-backed securities. Investors then snapped up the securities, reassured by the seals of approval bestowed by Moody's and S&P. Of course the ratings agencies had a conflict of interest so huge it was surprising that Washington regulators never had a Homer Simpson “d’oh” moment: Whichever bank created a security also paid for it to be rated. It's like a poor student who can buy good grades, except with more disastrous consequences, as we are now seeing.

How bad did it get? In an informal instant message exchange in April of last year, one S&P official expressed skepticism to another about a mortgage-backed security, saying the model being used for the rating “does not capture half the risk.” Then she made the snarky remark: “It could be structured by cows and we would rate it.”

Credit rating agencies are edging toward irrelevancy because they compromised their ideals and let their names be sullied in pursuit of short-term profits. Their very business model relies on their reputation and integrity of their work. When investors lose faith in their ability to evaluate products and entities, their role in the financial system becomes entirely superfluous.

They would be wise to remember Shakespeare who once wrote wisely, “He who steals my purse steals trash/but he that filches from me my good name robs me of that which not enriches him and makes me poor indeed.”

Tuesday, October 14, 2008

Hank Paulson: He Isn't One of Us

The John McCain line about Barack Obama could easily apply to the U.S. Treasury Secretary. Paulson, as you may recall, submitted an awful $700 billion bailout plan that was fortunately improved through the legislative process. But Paulson had to be dragged kicking and screaming into doing the right thing (agreeing to take ownership stakes in firms that take bailout money, so as not to leave taxpayers too much on the hook). He apparently preferred to just blow $700 billion on a mountain of bad assets and cross his fingers that they'll be worth something in five years.

Hank Paulson is now paid by the U.S. taxpayer, but he still hears most clearly the siren call of Wall Street, where he once headed Goldman Sachs and argued against regulations that could have helped avoid this current mess. Considering his conflicted heart, we would do well to monitor the Treasury closely during bank rescue operations. Paulson still wants to play Santa Claus; he has already said that the government will take only nonvoting preferred stock in banks it helps. That's like investing millions in a struggling company and then being told to keep your mouth shut about how they run things.

For the story, just read Felix Salmon’s astute and timely blog post here at

Monday, October 13, 2008

Fannie and Freddie: Not the Boogeymen

Check out this article from the Washington bureau of McClatchy Newspapers about why Fannie and Freddie shouldn't be the fall guys for the global financial crisis. The structure and logical flow are a bit choppy in places, but the central contention is dead on. It was good to see the authors argue the point forcefully, which newspaper reporters are often too timid or self-conscious to do. Anyway, the excerpt below shows how Fannie and Freddie were laggards in subprime lending, not leaders.

Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication. One reason is that Fannie and Freddie were subject to tougher standards than many of the unregulated players in the private sector who weakened lending standards, most of whom have gone bankrupt or are now in deep trouble.

During those same explosive three years, private investment banks — not Fannie and Freddie — dominated the mortgage loans that were packaged and sold into the secondary mortgage market. In 2005 and 2006, the private sector securitized almost two thirds of all U.S. mortgages, supplanting Fannie and Freddie, according to a number of specialty publications that track this data.

And Now a Word from our Sponsor

Now for some good news about the market for credit default swaps (those insurance-like products that guarantee the value of corporate bonds and mortgage-backed securities). These details are by way of a clearinghouse for trades that goes by the name Depository Trust and Clearing Corporation (DTCC).

* Pleasant surprise #1: DTCC, which claims to handle the "vast majority" of trades on credit default swaps, says it has registered $34.8 trillion of such contracts. That would make the credit default swap market about half of earlier estimates of $60 trillion, thus reducing its "neutron bomb" capacity for widespread destruction.

* Pleasant surprise #2: Less than 1% of its credit default swaps are for mortgage-backed securities. So, presumably, even if these securities (whose value rests on the fortunes of the cratering U.S. home market) take a tumble, that won't trigger huge CDS claims.

* Pleasant surprise #3: The net payout in the Lehman bankruptcy, from the sellers of credit default insurance to the buyers, will be about $6 billion, not $365 billion or some other ghastly-high figure. This is because, apparently, the players in this market are well hedged. In other words, if A owes B $30 billion, he's mostly covered because C owes him $29 billion.

The DTCC corrected all these misperceptions in an October 11 press release in which it decried "inaccurate speculation." What's going on here, I think, are several things. DTCC is trying to (1) quiet investor fears about swaps, (2) show that the products aren't part of some crazy Wild West marketplace being run off Uncle Jed's back porch, and (3) position itself for the coming onslaught of Washington regulation.

This disclosure is useful, though it helps underscore why there's so much concern about credit default swaps in the first place. The market has been operating in too many dark, unregulated corners. The fact that the net payout from the Lehman bankruptcy could have been misestimated by a factor of 60 shows how little is known about how these swaps work and who has how many of them.

Sunday, October 12, 2008

Halloween Costume Idea: Go as a Credit Default Swap

We are now entering a new roller coaster phase of the financial crisis. The G7 meeting this weekend produced little more than the illusion of a hint of group resolve. The communiqué that was issued contains fine-sounding principles but no plan of action. Markets will likely respond no more than if they had been slapped with a wet noodle.

The real news this week will be quietly going on behind the scenes: a scramble for cash to meet credit default swap obligations after the Lehman Brothers bankruptcy. That's a mouthful, and since I created this blog for curious people who aren't from the world of finance, I'll go slow here.

First, when you go bankrupt, your owners are wiped out. In Lehman's case, this means the stockholders. The bondholders, being creditors, are in a better position. They get to divvy what's left of the carcass, if you will. For every dollar they lent to Lehman, they may get 70 cents, 50 cents or even 10. Turns out, unfortunately, it's pretty close to 10 cents, as determined Friday.

So are the bondholders almost completely wiped out? Well, not so fast. If they owned credit default swaps, a sort of insurance on their bonds, they get to recover the remaining 90 percent. (Cue the rousing cheer sound effect.) So far, this sounds like a very savvy bit of Wall Street financial engineering, these credit default swaps, eh?

The problem, as with any insurance, is your insurer must have enough money to pay out the claim or the whole scheme falls apart. Large Wall Street banks and hedge funds have been happily writing credit default swaps and raking in the fat premiums for the last eight years. They don't have to show that they have sufficient funds to make good on the swaps because this market is COMPLETELY UNREGULATED. I could theoretically write one of these contracts from my bedroom, in my pajamas, with $26 in my savings account. And the CDS market has exploded in size to about $60 trillion. (That's the cost of about 100 Iraq wars).

Here's another wrinkle: you can buy these pseudo-insurance policies without even owning the underlying bond. In other words, it would be like taking out a fire insurance policy on Fred's house across town. You don't own the house, but you can collect when it burns down. That wrinkle matters hugely because it inflates the size of the CDS market. Lehman, I believe, had about $128 billion of bonds and an estimated $400 billion worth of credit default swap coverage on those bonds. This is where a CDS stops looking like insurance and more like a roulette wheel bet. Insurers write swaps for buyers who just want to take a flyer on whether or not Lehman will go belly up.

Now, to the heart of the matter: why this week could be especially turbulent in the markets. The insurers for the Lehman credit default swaps will have to start coughing up about $365 billion -- that's right, billion with a “b.” Now remember, the CDS market is totally unregulated, so no one is entirely clear who all these insurers are, or how much they’re on the hook for, or whether they'll be able to come up with the funds.

Two possible outcomes: 1. If some of the CDS insurers are cash-strapped hedge funds, they may have to sell off truckloads of stock to meet their obligations, driving down the Dow and S&P for yet another week. 2. If some of the CDS insurers are banks, the steep payouts could potentially bankrupt them. The second possibility is scarier, as it ushers in a death-spiral scenario: they go bankrupt, which triggers payouts on the credit default swaps on their own debt, which causes more bankruptcies, etc. etc.

This week and the next could be a major stress test for the credit default swap market. And then the whole thing starts anew with Washington Mutual's bankruptcy settlement at the end of this month. Better take some Dramamine.

Tuesday, October 7, 2008

Pin the Blame on the Donkey?

The search for a scapegoat in the U.S. financial crisis will reach new heights if markets around the world continue to gasp and flounder. Banks are still terrified to lend to each other. Who can you really trust in a high-stakes shell game where mounds of bad assets are hidden somewhere, but where exactly?

One narrative of the financial crisis would lay the blame at the feet of Fannie Mae and Freddie Mac. The two mortgage giants, conservatives contend with increasing vigor, were pushed hard by Congress (especially by Democrats) to lend more to low-income families who had poor credit. What brought this mess upon us, so goes this interpretation of events, were meddling politicians, not failures of regulation or the free market.

It’s a nice story, especially for those who tend to see bleeding-heart liberals behind every tree (or hugging every tree). But it’s like trying to put a size 6 foot inside a size 12 shoe – not a good fit. Sure, Fannie and Freddy screwed up. They did buy home loans made to risky borrowers. And their very structure seriously needs reform. Congress created a monster: private companies with public responsibilities. So they can take risk like a private firm, while knowing the government will be there to bail them out if they get in trouble. Uh oh.

Still, this crisis needed rocket fuel to take off. To be this severe, it needed something beyond a bunch of plain vanilla subprime loans going belly up. And that’s where Wall Street comes in. Firms on the Street dabbled in a lot of sophisticated financial engineering. They sliced and diced lousy mortgages like a financial Ron Popeil, creating a bewildering assortment of securities and derivatives. They pushed their levels of leverage from 12 to 1 to 30 to 1. In short, they made wild bets with massive amounts of borrowed money.

Wall Street embraced unheard-of levels of risk, and that’s the main story, though there were lesser culprits. It’s a complicated narrative that requires an understanding of an alphabet soup of products and entities: ABS, CLOs, CDOs, SIVs. Listeners also have to wrap their minds around the concept of credit default swaps to appreciate how the teetering tower got so tall. But I suspect in the weeks to come, Congressional hearings will give us all a crash course in the story of 21st century risk taking, Wall Street style – and how it brought us to this awful juncture.

Sunday, October 5, 2008

On the Lighter Side

From the “how NOT to do Wall Street PR” department
The photo above accompanied CNN’s Friday story about the House passing the financial rescue bill. I know the intent was to show Wall Street's jubilation. But what we got was this well-fed trader who appears to be laughing at, not with, the U.S. taxpayer (especially since the market took a dive Friday).

How to make your own financial crisis. Step one: get a snow blower. Step two: fill it with money. Step three: turn it on.

“I wouldn't have loaned me the money. And nobody I know would have loaned me the money.”
-- Clarence Nathan, as quoted in the New York Times. Nathan had no job and no assets, but received a $450,000 mortgage.

My favorite 15-word analysis of the Paulson plan, which Congress passed, to buy hundreds of billions of dollars of toxic financial assets:

Throw a trillion dollars down a rathole with no debate and no alternatives considered.
-- poster Jeffrey Knoll, in the comments section of Econbrowser.

Saturday, October 4, 2008

Gazing into the Crystal Ball

Congress, in an appalling failure of imagination, approved Treasury Secretary Paulson's wrongheaded plan to bail out financial firms that acquired too many risky assets. He got his $700 billion check (in installments) to start snapping up distressed bonds and other investments that have taken a tumble in the U.S. housing meltdown. Ironically, members of Congress who voted for the unpopular legislation will probably glumly console themselves that they made a tough but necessary stand. Come on. It requires little courage to play the role of the outraged lapdog. Not one of 535 legislators deemed it worthy to craft an alternative, despite all the better ideas put forth by economists on the right and left.

But what's past is past, so let's look forward. Here are my predictions for the post-bailout bill future.

1. This bill, despite all the hoopla, won't even be the big rescue effort. We’ll see a more aggressive, all-encompassing solution that will probably involve seizing banks. Once this moment arrives, look for a few commentaries on the themes of “Where the hell did that $700 billion go?” and “Why didn't we just do this in the first place?”

2. Now there will be a financial version of the Oklahoma land run, as companies from Singapore to Switzerland, carrying a Baskin-Robbins assortment of toxic financial waste created in America, race forward to dump it with the U.S. government. Look for brigades of lobbyists and politicians to step in and try to direct the spoils, since everyone knows that $700 billion won't be nearly enough to buy up all the crap out there.

3. Success has many fathers; failure is an orphan. When this rescue plan flops, look for at least one of its high-profile backers to disown it publicly (Paulson? Pelosi? Dodd?) This person will complain bitterly about not being told some vital bit of information, or about how the original good idea got perverted in the execution because of all those damned incompetent Washington bureaucrats/Democrats/Republicans.

4. There'll be a House cleaning when voters go to the polls in November.

Friday, October 3, 2008

The Bailout: The One Thing I Don’t Get

It’s early Friday morning. In hours, the House will vote on what would be a historic $700 billion bailout of Wall Street. The bill will likely pass, though it’s essentially the same as the version the House shot down on Monday. (The Senate sprinkled on some pork and tinkered with FDIC limits on deposit insurance.)

What’s puzzling is that, facing the financial crisis of a lifetime, Congress can’t manage to draft even one alternative to the lousy Hank Paulson plan at the heart of this legislation. They could’ve been working on something since Monday. They could’ve consulted the legion of economists who have burst forth brandishing better proposals. In fact, I have yet to read a worse idea than what the Treasury Secretary wants to do: Buy a slew of bad assets with taxpayer money while failing to directly recapitalize struggling banks. This seems exactly the prescription for a long, drawn-out endgame of this mess with the likelihood we’ll start chucking good money after bad.

There is a vibrant marketplace of ideas in a democracy; it is one of our greatest strengths. We have the right to debate and disagree: with each other, with our government. And during this crisis, the response in the financial blogosphere has been smart, electric, incisive. Many, many good ideas are circulating. But no one in Congress sees fit to offer even one rival bill to the deeply flawed Paulson plan.

I don’t get it.

Thursday, October 2, 2008

Your Bailout Bill, Presented by the Other White Meat

The Senate overwhelmingly passed a version of the bailout bill that, instead of taking the bull by the horns, seized the pig by the ears. Amid what may be the greatest financial crisis of their lifetimes, Senators rolled up their sleeves ... and began stuffing the legislation with pork. Most egregious example seen so far: a tax exemption for certain kinds of wooden arrows designed for children.

Now, if the House can browbeat a few members into switching their “nay” votes, the $700 billion rescue of Wall Street will be complete. That something needed to be done quickly was becoming frighteningly apparent. The New York Times did a nice job of laying out, in plain language, how the financial system could come undone.

It's a shame though that legislators crafted such a poor bill. They could've driven a hard bargain. They could've said to Wall Street firms, “Hey, we’ll buy your bad assets, even pump in capital, but we want to own a chunk of your company in return, no exceptions.” That would've scared away hundreds of opportunists from seeking bailout funds. Instead look for chaos as this plan unfolds and firms both domestic and foreign make a grab for that big, fat $700 billion mound of money.