Authors: Barry Ritholtz
Bailout Nation (21 page)
I
ndiscriminate lending by mortgage originators helped inflate the housing boom. While housing was an extended asset class, it was not a true bubble. To be sure, it was frothy as all hell, and some areasânamely California, Southern Florida, Arizona, and Las Vegasâwere bubblicious. But the actual bubble was found in credit. As of Q1 2009, house prices have corrected on a national basis about 25 percent, according to the Case-Shiller index.
ndiscriminate lending by mortgage originators helped inflate the housing boom. While housing was an extended asset class, it was not a true bubble. To be sure, it was frothy as all hell, and some areasânamely California, Southern Florida, Arizona, and Las Vegasâwere bubblicious. But the actual bubble was found in credit. As of Q1 2009, house prices have corrected on a national basis about 25 percent, according to the Case-Shiller index.
Credit, however, has absolutely collapsed.
At the center of it all was subprime lending, especially among the nonbank mortgage originators. They lent to unqualified borrowers, fed the derivatives market, and ultimately helped bring about a disasterâin housing, in subprime mortgages, and in mortgage-backed securities. This was the epicenter of the credit crisis.
What was their impact on lending? In 2004, 2/28 adjustable-rate mortgages (ARMs) accounted for almost 46 percent of new loans in dollar value and were about a third of total mortgages made, according to the Mortgage Bankers Association (MBA). That was up from 29 percent and 19 percent, respectively, in 2003. Subprime mortgage lending was one out of five mortgage loans in 2004, up from less than one out of 10 the year before.
Why would ARMs make up so much lending when mortgage rates were at their lowest levels in 50 years? The only possible answer was to sell moreâand biggerâloans. Getting people into teaser-rate mortgages, regardless of suitability, would get them past that default period covered by the initial warranty. This was the sub-prime mortgage industry's primary raison d'etre.
Ivy Zelman, the well-regarded housing analyst at Credit Suisse First Boston, noted the absurdity as early as 2006:
⢠In 2005, 32.6 percent of new mortgages and home equity loans were interest only, up from 0.6 percent in 2000.
⢠Forty-three percent of first-time home buyers in 2005 put no money down.
⢠In 2006, 15.2 percent of 2005 buyers owed at least 10 percent more than their home was worth (negative equity).
⢠Ten percent of all homeowners with mortgages had no equity in their homes (zero equity).
⢠Fully $2.7 trillion in loans were scheduled to adjust to higher rates in 2006 and 2007.
And those borrowers who convinced themselves an ARM would help them get into a bigger house until they could refinance (or flip the house) at a higher price? They were lying to themselves as they financially engineered their way into homes they couldn't afford.
M
ortgage brokers were big fans of refinancing. Those buyers who couldn't afford the mortgage in the first place were potential repeat customers down the road. As a house went up in value, you could always pull out the increase in equity to pay for the shortfall in monthly payments. Commission-driven real estate agents, along with the commission-driven mortgage brokers, liked to remind reluctant buyers that the longer they dithered, the higher prices were going.
Best to get in now before the next leg up in real estate values!
ortgage brokers were big fans of refinancing. Those buyers who couldn't afford the mortgage in the first place were potential repeat customers down the road. As a house went up in value, you could always pull out the increase in equity to pay for the shortfall in monthly payments. Commission-driven real estate agents, along with the commission-driven mortgage brokers, liked to remind reluctant buyers that the longer they dithered, the higher prices were going.
Best to get in now before the next leg up in real estate values!
It is no surprise that these were the first mortgages to default. Disproportionately, subprime adjustable-rate mortgages have had the highest foreclosure rates of all mortgages. Rather than being “contained,” as Ben Bernanke and Henry Paulson (among other so-called experts) claimed throughout 2007, the subprime mortgage caused a cascade reaction all the way through the entire financial system.
And the mortgage-based fun was only just beginning.
INTERMEZZO
A Memo Found in the Street: Uncle Sam the Enabler
To:
Washington, D.C.
From:
Wall Street
Re:
Credit Crisis
Washington, D.C.
From:
Wall Street
Re:
Credit Crisis
Â
Dear D.C.,
Wow, we've made quite a mess of things here on Wall Street: Fannie and Freddie in conservatorship, investment banks in the tank, AIG nationalized. Thanks for sending us your new trillion-dollar bailout.
We on Wall Street feel somewhat compelled to take at least some responsibility. We used excessive leverage, failed to maintain adequate capital, engaged in reckless speculation, and created new complex derivatives. We focused on short-term profits at the expense of sustainability. We not only undermined our own firms, we destabilized the financial sector and roiled the global economy, to boot. And we got huge bonuses.
But here's a news flash for you, D.C.: We could not have done it without you. We may be drunks, but you were our enablers. Your legislative, executive, and administrative decisions made possible all that we did. Our recklessness would not have reached its soaring heights but for your governmental incompetence.
This memo provides a brief history of your actions that helped create this crisis.
1997:
Federal Reserve Chairman Alan Greenspan's famous “irrational exuberance” speech in 1996 was somehow ignored by, um, Fed Chairman Greenspan. The Fed missed the opportunity to change margin requirements. Had the Fed acted, the bubble would not have inflated as much, and the subsequent crash would not have been as severe.
Federal Reserve Chairman Alan Greenspan's famous “irrational exuberance” speech in 1996 was somehow ignored by, um, Fed Chairman Greenspan. The Fed missed the opportunity to change margin requirements. Had the Fed acted, the bubble would not have inflated as much, and the subsequent crash would not have been as severe.
1998:
Long-Term Capital Management was undercapitalized, and used enormous amounts of leverage to purchase all manner of thinly traded, hard-to-value paper. It failed, and under the authority of the Federal Reserve a private-sector rescue plan by banks was cobbled together. Had these bankers suffered big losses from LTCM, they might have thought twice before jumping into the exact same business model of undercapitalized, overleveraged, thinly traded, hard-to-value paper. Instead, they reaffirmed Benjamin Disraeli's famous aphorism: “What we learn from history is that we do not learn from history.”
Long-Term Capital Management was undercapitalized, and used enormous amounts of leverage to purchase all manner of thinly traded, hard-to-value paper. It failed, and under the authority of the Federal Reserve a private-sector rescue plan by banks was cobbled together. Had these bankers suffered big losses from LTCM, they might have thought twice before jumping into the exact same business model of undercapitalized, overleveraged, thinly traded, hard-to-value paper. Instead, they reaffirmed Benjamin Disraeli's famous aphorism: “What we learn from history is that we do not learn from history.”
1999:
The Financial Services Modernization Act repealed Glass-Steagall, a law that had separated the commercial banking industry from Wall Street, and the two industries, plus insurance, came together again. Banks became bigger, clumsier, and harder to manage. Apparently, risk management became all but impossible, even as banks had greater access to larger pools of capital.
The Financial Services Modernization Act repealed Glass-Steagall, a law that had separated the commercial banking industry from Wall Street, and the two industries, plus insurance, came together again. Banks became bigger, clumsier, and harder to manage. Apparently, risk management became all but impossible, even as banks had greater access to larger pools of capital.
2000:
The Commodity Futures Modernization Act defined financial commodities such as “interest rates, currency prices, and stock indexes” as “excluded commodities.” They could trade off the futures exchanges, with minimal oversight by the Commodity Futures Trading Commission. Neither the Securities and Exchange Commission (SEC) nor the Federal Reserve, nor any state insurance regulators, had the ability to supervise or regulate the writing of credit default swaps by hedge funds, investment banks, or insurance companies.
The Commodity Futures Modernization Act defined financial commodities such as “interest rates, currency prices, and stock indexes” as “excluded commodities.” They could trade off the futures exchanges, with minimal oversight by the Commodity Futures Trading Commission. Neither the Securities and Exchange Commission (SEC) nor the Federal Reserve, nor any state insurance regulators, had the ability to supervise or regulate the writing of credit default swaps by hedge funds, investment banks, or insurance companies.
2001-2003:
Alan Greenspan's Fed dropped federal funds rates to 1 percent. Lulled into a false belief that inflation was not a problem, the Fed then kept rates at 1 percent for more than a year. This set off an inflationary spiral in housing, as well as a desperate hunt for yield by fixed-income managers.
Alan Greenspan's Fed dropped federal funds rates to 1 percent. Lulled into a false belief that inflation was not a problem, the Fed then kept rates at 1 percent for more than a year. This set off an inflationary spiral in housing, as well as a desperate hunt for yield by fixed-income managers.
2003-2007:
The Federal Reserve failed to use its supervisory and regulatory authority over banks, mortgage underwriters, and other lenders, who abandoned such standards as employment history, income, down payments, credit rating, assets, property loan-to-value ratio, and debt-servicing ability. The borrower's ability to repay these mortgages was replaced with the lender's ability to securitize and repackage them.
The Federal Reserve failed to use its supervisory and regulatory authority over banks, mortgage underwriters, and other lenders, who abandoned such standards as employment history, income, down payments, credit rating, assets, property loan-to-value ratio, and debt-servicing ability. The borrower's ability to repay these mortgages was replaced with the lender's ability to securitize and repackage them.
2004:
The SEC waived its leverage rules. Previously, broker-dealer net capital rules limited firms to a maximum debt-to-net-capital ratio of 12 to 1. This 2004 exemption allowed them to exceed this leverage rule. Only five firmsâGoldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanleyâwere granted this exemption; they promptly leveraged up 20, 30, and even 40 to 1.
The SEC waived its leverage rules. Previously, broker-dealer net capital rules limited firms to a maximum debt-to-net-capital ratio of 12 to 1. This 2004 exemption allowed them to exceed this leverage rule. Only five firmsâGoldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanleyâwere granted this exemption; they promptly leveraged up 20, 30, and even 40 to 1.
2005-2007:
Unscrupulous home appraisers found that they could attract more business by inflating appraisals. Intrinsic value was ignored, so referrals kept coming in. This helped borrowers obtain financing at prices that were increasingly unsupportable. When honest appraisers petitioned both Congress and the bureaucracy to intervene in the widespread fraud, neither branch of government acted.
Unscrupulous home appraisers found that they could attract more business by inflating appraisals. Intrinsic value was ignored, so referrals kept coming in. This helped borrowers obtain financing at prices that were increasingly unsupportable. When honest appraisers petitioned both Congress and the bureaucracy to intervene in the widespread fraud, neither branch of government acted.
There's actually a lot more we could add to these items. We could mention impotent supervision of Fannie and Freddie by the Office of Federal Housing Enterprise Oversight, the negligent oversight on rating agencies, the Boskin Commission's monkeying around with how inflation gets measured, the Greenspan put, and so on.
We could mention former Fed Governor Edward Gramlich, who warned about making home loans to people who could not afford them, and who said the runaway subprime mortgage industry would create problems in housing and the credit markets. But Gramlich was up against a Fed chairman who apparently believed that markets can regulate themselves. (Gramlich died in 2007, three months after the housing bubble started to deflate.)
We on Wall Street do not deny our part. We created these securities, we rated them triple-A, and we traded them without understanding them. Now that they have gone bad, we are really close to getting the rest of the country to take them off our hands.
Thanks, D.C. None of this would have been possible without you.
Â
Very truly yours,
Wall Street
Chapter 11
Radical Deregulation, Nonfeasance
Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief.
âAlan Greenspan, Senate testimony, October 22, 2008
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H
ow the United States ended up a Bailout Nation is more than the work of just one man. Sure, Alan Greenspan looms large in this story, and in more ways than one. But it took the creative irresponsibility and misguided philosophy of many players to create the massive debacle that has enveloped the global economy. Presidents, senators, Securities and Exchange Commission (SEC) chairmen, Treasury secretaries, and members of Congress all contributed.
ow the United States ended up a Bailout Nation is more than the work of just one man. Sure, Alan Greenspan looms large in this story, and in more ways than one. But it took the creative irresponsibility and misguided philosophy of many players to create the massive debacle that has enveloped the global economy. Presidents, senators, Securities and Exchange Commission (SEC) chairmen, Treasury secretaries, and members of Congress all contributed.
A brief review of modern U.S. regulatory history shows where the United States made its wrong turn, and the consequences of those errors.
Following World War II, the world set about righting itself. The Marshall Plan was helping to rebuild Europe; Japan became a cheap source of industrial manufacturing. Millions of GIs returned home to the land of opportunity. Returning veterans had the benefit of the GI Bill, which meant free college or vocational school and low-cost loans to buy homes or start businesses. The nascent growth of suburbia also contributed to economic activity. The U.S. economy was expanding, and it led the rest of the world into a period of rapid growth.
Along the way, the government's bureaucracy also began expanding. Twenty years after the war, complying with U.S. regulatory oversight was increasingly complex, time-consuming, and expensive for American businesses. By the late 1960s, the many rules and regulations were a costly part of doing business. It wasn't too much later when politicians seized on the concept of reducing costly regulations. It soon became a political rallying cry.
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