Friday, January 6, 2012

Collapse of 2008

The recent Fannie & Freddie discusion which tries to apportion blame for the mortgage meltdown lays the blame on the government and F & F itself. Yes, they both deserve part of the blame -- the government for it's lax regulation and hands off policy (see Greenspan's statements on self regulation), and F & F for trying to compete by lowering it's standards. What I find missing from today's discussion is the role of Wall Street money (the elephant in the room) in fueling the housing bubble. This made me search out my notes from 2008. Here's what I wrote at that time. (Please note it's not sourced as I was writing for myself, in my own shorthand, pre blog. BF emphasis was done today)

<<<<  In 2001 economy was already in recession after the collapse of the dot com boom. After 9/11/01 Greenspan feared collapse and started lowering interest rates. Mortgage rates declined, housing boom started.

As housing prices increased, affordability decreased. “Creative financing” was needed. The “opportunity” came with accounting scandals in Fannie & Freddie.  F & F traditionally bought mortgages from mortgage originators (usually banks). They then packaged the mortgages & sold them as Mortgage Backed Securities - MBS, primarily to pension funds & institutions, who only bought investment grade securities (AAA to BBB). F & F were dominant in the market so they dictated terms and those terms were very strict. A documented mortgage could take up to 90 days. Wall Street had always salivated over this business and for years had been pressuring Congress to do away with F & F.

After the scandal, F & F lost market dominance, so mortgage originators needed another source of cash. That is what Wall Street was waiting for. In 2001 & 2002 Wall Street was awash with cash from petro dollars and emerging economies. It poured the money into mortgages. Unlike F & F it did not care about standards, as it immediately packaged them into Collateral Debt Obligations - CDOs, and sold them all over the world collecting huge fees. With home prices rising & affordability declining a solution was found via Orange County and creative financing – no doc loans. (Countywide)  Wall Street was able to do this with the collusion of credit rating agencies & the financial engineering of CDOs.

CDOs were engineered by several geeks at Bear Stearns. (Basically, another level of derivative of MBS)  MBS are sliced and repackaged into a new product – CDO, which holds slices of numerous MBS. (Greenspan admitted he’d read several prospectuses of CDOs and could not understand them). CDOs were created not only with mortgages but with corporate & municipal bonds. (Staples Center, Films, etc)  Anything that could show a future income stream could potentially be securitized, sold, and fees collected. Rating agencies (only 3) were paid by the banks that issued the securities. If a bank did not like the rating they could always go to another agency. So, the agencies were incentivized to provide the highest rating possible. Their formulas assumed house prices would rise 6% - 8% per year forever. After all, there had not been a single down year in house prices since the Great Depression. Additionally they designed mathematical models, which gave a AAA rating to CDOs that contained 80% AAA and 20% junk.

In 2004 Bush made his push for the ownership society and Greenspan responded – in a speech he encouraged the mortgage industry to devise “product alternatives” to increase home ownership. The result – negative amortization loans.

At this time F & F reentered the market and started doing sub-prime loans. Prior to 2004 loan volume had been running at 50 billion/year. After 2004 it was 300 billion per year. By 2005 sub-prime made up 20% of the mortgage market.

The SEC never even questioned the banks about these structured products. They believed the banks would regulate themselves. The mortgage origination business was totally unregulated and the finance companies got their AAA rating from the agencies and Wall Street sold the products all over the world.

By the first quarter of 2006 mortgage delinquencies started rising and Wall Street cut off credit to the mortgage originators.  With no new mortgages, and no new buyers, housing prices started declining. This killed the refi market and adjustable rate buyers could not refi when the teaser rate ended nor could they sell in a declining real estate market. Investors around the world realized AAA was junk and credit stopped.

This describes what came to be called the “shadow” banking system. At one time, traditional banks wrote mortgages and kept them on their books. This system was regulated. The shadow system is totally unregulated because banks don’t issue mortgages they only buy them, package them as CDOs and sell them. And CDOs and “originators” are unregulated.
And then there are SWAPs -  insurance on CDOs, another level of derivative. Again unregulated. The shadow banking system is huge and it is part of the traditional banks. There is no end in sight if they securitize every income stream they can identify.  >>>>

Finance Capital, rightly, is in search of the a return and will always flow towards the highest return. But, given todays wealth concentration and the structure of the markets, (exponentially increasing derivatives products) a limited number of individuals, commanding huge sums can sway markets. (hedge funds)  Thus we get bubbles and crashes, with greater and greater frequency. (emerging markets, dot com, oil spikes and then crashes - 1987, 1998, 2000, 2008) 

Neoclassical Free Market ideology set the table for the mortgage debacle -- repeal of Glass-Steagall, the constant drone of anti-regulation rhetoric, regulatory and government capture, and finally Chairman Greenspan declaring that the financial industry was capable of self-regulating. In 2001 Wall Street needed a new "investable" market for it's billions. It saw the opportunity and supplied mortgage originators with cash in return for mortgages. Financial engineering created products based on those mortgages to be sold and traded. Wall Street profited by collecting fees and by trading those products, at times even taking positions counter to the product they were pushing to their customers. The profits rolled in. It was so profitable that Wall Street firms (Bear Sterns, Morgan Stanley, Goldman Sacks and major banks)  kept pushing out the money and demanding more product for its  financial packaging industry.

And that is the way the game was played until the music stopped in 2008. 

1 comment:

  1. Bravo. A cogent and concise analysis. The verdict? They all belong in jail, or the very least fired and forced to work alongside the rest of us 99%. Unfortunately, neither will happen under Obama or any other administration; all the more reason to critique and expose.