The View Through the Bushian Looking Glass

GM got a stern dressing down when it showed up in Washington with Detroit's other suffering automakers, hat in hand, seeking a bailout. Would you rescue an outfit with these characteristics:

The company is on shaky financial footing, perhaps insolvent. It is guilty of overpaying workers (blue-collar employees got generous union contracts that provided unsustainable benefits). Its core business suffered from stunningly bad decisions (not developing enough good high-mileage or green vehicles, for example, leaving the company with unpopular products it has trouble selling).

The verdict: Let it perish! But what about the following supplicant:

The company is on shaky financial footing, perhaps insolvent. It is guilty of overpaying workers (white-collar executives got outrageous bonuses and salaries that didn't reflect the long-term viability of the operations they oversaw). Its core business suffered from stunningly bad decisions (taking on too much leverage and acquiring risky, complex securities, leaving the company with unpopular products it has trouble selling).

The verdict: Save it at any cost!

Of course this second example is Citigroup. The financial giant not only received a bailout, but the terms were astonishingly generous. First Citigroup gets a $20 billion loan. Then the federal government agrees to backstop its losses on $306 billion of potentially crappy mortgage-backed securities. That's billion with a “b.” Worst-case scenario, taxpayers would be on the hook for roughly $250 billion on the backstop provision alone. That's more than ten times how much the embattled Big Three automakers sought to borrow, only to be rebuffed.

To be clear: GM shouldn't get a rescue package, not without a tough shakedown. But what about Citigroup? I know it's large. I know letting it fail would be akin to letting die the guy in the science-fiction film whose body is teeming with highly virulent viruses that, if he expires, will explode into the air and perhaps wipe out civilization.

But can’t the Bush team knuckle down and drive a hard bargain with at least one of these financial companies, especially since they’re bargaining from a position of weakness? It’s really baffling.

Give Me a Lever Long Enough and I'll Buy the World

When the definitive history of this financial crisis is written, the role of leverage should get a hard look. In the ailing credit markets, leverage turned what should have been chest pains into a full-blown heart attack. The “seize up" metaphor became especially apt.

Those following the storyline closely will know that leverage at Wall Street investment banks soared from levels of 12-1 to 30-1 in about four years. But what does that mean? To the average guy on Main Street, leverage is a rather abstract, foreign concept. However it's critical to grasp the destabilizing power of leverage to understand the mess we're in.

The standard definition of leverage compares money borrowed to equity. So if you take out a $3 million loan and your only equity is a $300,000 house, you’re leveraged at 10-1. But there's another way to look at this idea that illustrates the vulnerability created.

Let's say you buy a stock option (that financial engineers have dreamed up) that behaves this way: it costs $3.33 and captures the return on a $100 share of stock. That's leverage at 30-1. The upside is wonderfully lucrative. If that stock gains a bit more than 3 percent, you double your investment. Beautiful, you may be thinking. The only problem is that when it drops the same amount, you find yourself wiped out. So leverage magnifies risk.

Dizzying amounts of leverage contributed to the demise of Long Term Capital Management in 1998. When it began to implode, the firm had $4.9 billion of capital supporting a towering, Seussian edifice of $1.25 trillion of positions not reflected on its balance sheet. LTCM effectively had no cushion to fall back on when setbacks in the market began eating up its capital.

When LTCM began crumbling, the Federal Reserve had to intervene to ensure an orderly dismantling of the company. LTCM had become too big to let it simply collapse. Sound familiar? One takeaway lesson should have been that financial regulators need to closely monitor levels of leverage in the system. But somehow we lost sight of that.

Wall Street’s Deafening Silence

Throughout the long dark days of this financial crisis, one thing that has struck me is the silence of Wall Street’s public relations machines. I keep waiting for one bank, any bank, to give us their best-spin version of what went wrong, or why they aren’t as bad as all those others – or to say something. Surely they must see how vilified they have become. Shareholder activist Nell Minow even quipped that the Street is one bonus away from having the villagers descend with torches.

But when “60 Minutes” did its exposé on the financial crisis early on, none of the major Wall Street banks would comment, apparently in any form. None of them even sent what I call the “coward’s note” – that carefully crafted defense/statement that is read on air at the end of the broadcast segment. Later, when the bank CEOs went to Washington to sign off on billion-dollar bailouts, they left the meeting with Treasury Secretary Paulson and fled to their limousines. They adroitly dodged the press corps waiting outside. None of them did so much as issue a short statement of thanks or say that the money would help them extend more loans to unfreeze the credit markets.

How to explain this total silence? Partly it may stem from a “duck and cover your ass” mentality: anyone who raises his head to defend himself at this unsettled time may just draw more incoming fire. Also the more you say, the more ammunition you supply prosecutors and lawyers busy cobbling together investigations and lawsuits related to the financial meltdown. But the biggest reason may be simply that Wall Street’s largest banks realize how badly they screwed up.

When you think you’re an innocent man, you want to shout your message to the world. When you think you’re innocent to some degree, you seek ways to disseminate your version of events. When you think you’re guilty as hell, you shut up and pray for an earthquake or something that will bump news of your misdeeds off the front page.

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.

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.

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.”

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 Portfolio.com.