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The Mess in the US

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By FrugalFranco
December 4, 2008

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

Over the last month I have been linking the posts in a series I called "The Mess in the US." I just finished up the fourth and final installment, which can be found here -- http://frugalfranco.com/2008/12/the-mess-in-the-us4/ . I'm also copying the entire series below (although the humor from the hyperlinks on the site will be lost) for anyone who is interested and has a lot of time on their hands to read ;). All feedback is always welcome. Ciao, Franco

PART I

Falling home values, growing unemployment, plunging stock prices; how did we get into this mess? Well, in order to fully understand our current economic funk, we need to go back and examine the roots of what has now been coined "the credit crisis." So take a walk with me down memory lane while we explore the origins of securitized loans and unregulated swap contracts in a fascinating tail of innovation, riches, stupidity, and good ol' fashion greed.

Our story begins in an era know as the 1980's...Ronald Regan has declared war on the evil empire, Michael Jackson is better know for his music than his sleepovers, rock bands wear more makeup and hair spray than supermodels, and the S&P 500 sits at a lofty 150 points. With the stock market yielding little to no returns over the last decade and a half, the "hot money" is not in equities (stocks). The place to be if you are a big shot on Wall Street is in bonds and other fixed income products. One such product is a mortgage backed security (MBS). These securities, along with their slightly sexier cousin CMO (collateralized mortgage obligations), became the belle of the 1980's ball on trading floors across Wall Street.

Before the dawn of securitized loans (MBS, CMO, etc.), banks and brokerages would just trade individual home loans, know as "whole" loans. The process of trading whole loans is cumbersome and involves a large amount of paperwork in order to transfer ownership (anyone who has ever refinanced a loan can attest to this). The MBS was designed to combat this issue by creating a tradeable security that was backed by a group of individual whole loans. The originator of the MBS typically purchases whole loans, bundles them together, provides credit for the new security (guarantees the principal and interest payments of the underlying mortgages), has the security rated by a rating agency, and then brings the new security to market where it can be traded in the secondary market. In addition to the liquidity benefit (being able to purchase a sell the new security with easy), securitized loans also provide a diversification benefit by spreading the risk of default over a wide group of whole loans (as opposed to buying a single whole loan and hoping for the best).

The very first MBS arrived on the scene back in the 70's when the Government National Mortgage Association (GNMA or Ginnie Mae) started bundling home loans that were being originated by various government branches within the U.S. Department of Housing and Urban Development (HUD). These branches were set up to help lower income families realize the "American dream" of owning a home by using the "full faith and credit" of the US government to back the riskier loans. The advantage of securitizing these loans from the lender's (the US government in this case) perspective is that it frees up capital, which allows the lender to go out and make more loans. As an example, let's say that I lend my friend $1,000 and she agrees to pay me back $1,100 a year from now. Assuming this is all the money I have to lend out, if someone else came to me for a loan, I would have to turn them away. As an alternative, if I could sell my loan to another investor for say $1,010, I would realize an immediate $10 profit and have my principal back to lend out all over again.

Although the invention of the MBS was an innovative way for banks to free up capital and invest in the US housing market, they still weren't a huge hit for many fixed income investors for one reason - prepayment risk. Anyone who takes out a mortgage has the option of paying it off before it comes due. Loans can get paid off for a variety of reasons, but the most likely scenarios are a refinance when interest rates drop or a home sale. Taking a look at the first scenario, if a bank has an outstanding loan at 7% interest and interest rates drop to 5.5%, the last thing they want to happen is for the person with the 7% loan to pay it off, but this is typically the case in this scenario. If the loan does get paid off, the bank will then have to turn around and invest (by making another loan) the proceeds at the current, lower interest rate of 5.5%. What I've just described is known as prepayment risk and it is the primary drawback for investing in mortgage backed securities versus other fixed income investments with a standard, predetermined time line for interest and principal payments. To fix this problem, the innovative minds on Wall Street came up with a more appealing securitized loan known as a CMO (collateralized mortgage obligation).

The only major difference between a CMO and a MBS is that a CMO includes different tranches to help control prepayment risk. A pecking order is established for each tranche within the CMO and investors can choose the tranche that best fits their investment objective. The tranches at the bottom of the pecking order are the first to absorb any prepayments. The highest tranche in the pecking order known as the "senior tranche" will not see any prepayments until after all the supporting or subordinate tranches have been completely paid off. Subordinate tranches are typically offered at a higher interest rate than the senior tranche because of the increased level of prepayment risk. Basically, if an investor is willing to take on more risk, they will potentially reap a higher reward (higher interest rate = higher return on investment).

The creation of the CMO security greatly pleased Wall Street bond traders as they were now able to tap the giant, relatively untraded US mortgage market with a variety of securities that closely represented a typical bond with a stated interest rate, credit rating, and predictable cash flow. The new securitized loan market combined with the equally new and exciting junk bond market gave rise to a whole new fixed income culture on Wall Street. A culture that once was reserved for old, stodgy investors had now become a Wall Street gold mine. Financial legends such as Michael Milken and John Gutfreund, both of whom were immortalized in Michael Lewis' book Liar's Poker (an entertaining and highly recommended read), saw their star's and fortunes rise to astronomical heights during this hot decade for fixed income.

So the stage is set with the roaring 80's in full swing and securitized loans growing like wild fires. In the next installment we'll take a look at Wall Street's fallout during the Savings & Loan crisis of the early 90's along with the invention of a dangerous little gem known as a credit default swap.


PART II

We last left off with a red hot financial market in the mid 1980's being led by the fancy MBS (mortgage backed security) and CMO (collateralized mortgage obligation) securities running in tandem with a leveraged paradise known as the junk bond market. The easy money and lavish lifestyles of the 1980's were not isolated to Wall Street. Savings and loan (S&L or "thrifts") institutions across the nation were taking advantage of the newly implemented Tax Reform Act of 1986. The new act was passed to update "old banking standards" and allow thrifts to take on more risk in order to better compete in the "complex financial markets" of the 1980's. Thrifts ran with their new found freedom and grew like wild fire. Some of the more aggressive ones were doubling in size every year with less than ethical lending practices. All this easy money was making thrift executives very rich and further compounded the greed running rampant through the markets of the 80's.

The fun finally stopped when the "S&L Crisis" hit in the waning years of a decade best known for the King of Pop, mall bangs, and the chia pet. During the crisis, thousands of thrifts failed, housing markets went south, the economy fell into a recession, and the US tax payer was left holding the bag to support a government bailout of the failing S&Ls (sound familiar?). The details of the crisis are beyond the scope of our discussion, but suffice it to say that relaxed lending standards and excessive leverage (using OPM...other people's money), led to the then largest financial crisis since the Great Depression. The go-go age of easy money and risky lending practices had come to an end...for the time being.

The birth of the high tech sector gave rise to the 90's bull market and pulled the US economy out of its slump. The technology boom ushered in one of the longest bull markets in US history as investors began to believe that "this time it was different" with a new age of development. The tech heavy NASDAQ index grew almost 900% over the decade. Technology was not only changing people's lives, but it was changing the makeup of the market as well. At the beginning of the decade, technology related stocks made up only 7% of the broad S&P 500 index. By the end of the decade they accounted for nearly 30% of the index.

During the heart of the technology led bull market, something known as the Asian Financial Crisis emerged in 1997 when Asian countries started defaulting on their debt. The relatively young financial system in many Asian countries was weak and suffered from a lack of substantial governance. The inadequate oversight and poor assessment of financial risk led to a dramatic currency devaluation for several Asian countries. As the local currency became less and less valuable, it became impossible for companies and banks to pay off foreign debt (if a company is making money in a local currency that is rapidly devaluing and having to pay off debt in a stronger, foreign currency they are in deep kimshe). The crisis resulted in a sharp decline to the growth of many Asian countries as businesses collapsed and millions of people fell below the poverty line.

Foreign investors were also impacted by the Asian Financial Crisis as a string of defaults on Asian debt left many lenders "up the creek without a paddle." To avoid repeating this precarious situation, the market brought forth a new product known as a credit default swap (CDS). In its most basic form, a CDS is nothing more than an insurance agreement between two counter-parties. The purchaser of a CDS is looking to insure against catastrophic loss (other companies defaulting on debt that they own) in return for a small premium and the seller of the CDS is willing to take on additional risk in return for the premium. When done in this manner, a CDS could be used as a way to hedge a portfolio of fixed income investments. The agreement is similar to purchasing auto or home owner's insurance on one's car or property. Unfortunately, that is where the similarities between insurance and a CDS stop.

Unlike insurance, CDS contracts are unregulated, which opens the door to a variety of subtle nuances. First off, a CDS is a bilateral agreement between counter-parties. It is not an exchange traded product, it does not have a quoted market value, and in most cases, it is not accounted for on a company's financial statements. Because of all these factors it is very difficult to pin down exactly how many CDS contracts are outstanding, how many offset each other (e.g. buy a CDS with counter-party A and sell a CDS on the same underlying security to counter-party B), and who has exposure to what.

Another major difference between the insurance business and the CDS marketplace is the collateral requirements for companies selling (writing) the contracts. In the regulated insurance industry, companies are required to have a minimum amount of assets on hand in order to offset a portion of their outstanding liabilities. In the CDS market place, no such regulation exists. Under this "buyer beware" structure, it is possible for a very small counter-party to write large CDS contracts in order to collect bigger premiums knowing full well that they may not be able to make good on the claim if the underlying security ever defaulted.

The last major difference between purchasing insurance and a CDS is the fact that one does not need to own the underlying security in order to enter into a CDS. This would be akin to someone taking home insurance out on their neighbor's house in hopes that something bad might happen to it so that they can collect on their contract. When one enters into this type of agreement without having any exposure (financial risk) to the underlying asset, the CDS stops acting as a hedge (insurance) and becomes a speculative bet.

The CDS revolutionized the financial markets and how counter-parties viewed risk. The CDS industry was estimated to be in the "tens of billions of dollars" when it first started in the mid 90's and grew to an estimated value of over 55 trillion dollars today. Risk became a commodity that could be purchased and sold by anyone with a phone, a pen, and a piece of paper (and connections to institutions with large fixed income exposure). The catalyst behind the meteoric rise in the CDS market was still to come as our friends MBS and CMO came back to play during the US housing boom at the dawn of the 21st century. But we are getting ahead of ourselves as we have not yet covered the bursting of the tech bubble and the aggressive monetary policy that led to largest housing bubble in US history.


PART III

In the first two parts of this series, we covered the rise of securitized loans and birth of credit default swaps. We left off in the throngs of a raging bull market being driven by a new era of technology companies. With the exception of a few hiccups ( this one too), Wall Street has perpetuated almost 20 years of wealth creating, bull market returns on the backs of financial leverage, innovation, and good ol' fashion greed.

The booming 90's came to a screeching halt at the turn of the century, when the "dot-com bubble" finally burst. Technology stocks, especially anything even remotely related to the Internet, were trading at astronomical valuation levels on pure speculation that at someday in the future these dot-com companies would be making loads of cash. Once the market realized that "the emperor has no clothes," investors bolted for the door, yanking the much needed capital (money) that non-profit producing start up companies needed to survive. During this time, some companies like Enron, WorldCom, and Tyco were exposed for investor fraud and eventually went bankrupt. In the midst of all this, the US also suffered it's first attack on US soil since the bombing of Pearl Harbor in 1941. It was a dire time for many Americans as the US was slipping into a recession and fear of another terror attack weighed on people's hearts and minds.

In an attempt to stimulate the economy, the Federal Reserve Bank (commonly know as "the Fed") systematically slashed the Fed Funds rate all the way down to 1%. To give some background, banks are required by law to maintain a certain level of reserves to back up their portfolio of loans. If they fall below the reserve amount, they can borrow funds from other banks who have excess reserves. The nominal Fed Funds rate is the target interest rate at which banks should lend money to each other and is set by the Fed. The effective Fed Funds rate is the actual rate at which banks lend from each other. The Fed tries to bring these two rates closer together through open market activity (e.g. if the effective rate is too high, the Fed injects more money into the system making it easier to get a loan, so banks have to drop their rates to stay competitive). A bank makes a profit on the spread between the rate at which they borrow and the rate at which they lend out. With the cost of borrowing at historical lows, banks were able to lend out funds at very attractive rates making it extremely easy for people to get their hands on OPM (other people's money).

There was no bigger winner from the Fed's fast and loose monetary policy than the US housing market. With the stock market tanking and the cost of debt at historic lows, money started to pour into real estate markets. Americans started to "up size" their homes and investors began to jump into the market. As the number of buyers started to out-pace sellers, prices adjusted upward to match supply with demand (a little econ 101). This in turn attracted more money into the market as people began to flip houses for profit, which added to the demand and further perpetuated the housing market's meteoric rise. Homeowners became "house-rich" and cash poor, so they turned to home equity loans to tap some of this new found wealth. This money in-turn was dumped back into the economy as Americans continued to feed their spending addiction. The spending spree stimulated economic growth, pulled the US markets out of a recession, and put the bull market back on track.

Historically, under "normal" market conditions, the average home owner purchases a home worth three to four times their annual household income. During the peak of this profligate housing boom, the average house sold for five times (a 50% increase) household income with some hot markets along the coasts hitting much higher levels (to find the current average ratio in your area, check out this site). Housing prices rose to unsustainably high levels, which was perpetuated by both aggressive lending practices and Congressional posturing.

Back in the day, when someone wanted to buy a house they would go to a bank or a thrift for a loan. The lender would then originate the loan, keep it on their balance sheet, and service it until it was paid off or defaulted. The beauty of this simple system is that each lender was keenly aware of the risk they were taking by making loans to each Joe Soon-to-be-Homeowner that walked through the door. But as we've previously addressed, this all changed with the dawn of the securitized loan market. Under the new world of mortgage lending, loan originators were stand alone entities (Countrywide is a good example) who's compensation was more closely aligned to the quantity of loans created rather than the quality.

In order to keep the lending spigot flowing at full blast, loan originators created new, exotic loans that offered stated income, teaser rates, interest only, and balloon payment features. The details of these exotic terms are beyond the scope of this discussion, but all of them tweaked the characteristics of a conventional fixed rate amortizing loan. The primary purchasers of these loans were the securitization firms (mainly Frannie Mae and Freddie Mac) who took the loans, packed them together, and sold them to investors (primarily banks). Packaged loans were being analyzed by outdated computer programs which were not fully capturing the risks associated with these exotic new products. Marc Gott, a former director of Fannie Mae's loan servicing department was quoted as saying: "We didn't really know what we were buying. This system was designed for plain vanilla loans, and we were trying to push chocolate sundaes through the gears." But that didn't stop the machine from pumping out new securitized products backed by "chocolate sundaes." As long as the rating agencies (who's financial interests were also aligned with the number of loans they rated) signed off on the methodology and put a triple AAA rating on the product, securitization firms could sell them with easy and therefore also cared more about the quantity versus the quality of loans they purchased.

Adding to this massive tailwind was Congress pushing both Fannie and Freddie to take more risks and keep the breakneck pace going. Whenever anyone would suggest that Congress rein in the giant pseudo government lenders, lawmakers where hit with a barrage of angry phone calls and letters. One such automated phone call warned, "Your congressman is trying to make mortgages more expensive. Ask him why he opposes the American dream of home ownership." To make matters worse, Wall Street decided to jump into the market as investment banks like Bear Sterns, Lehman Brothers, and Goldman Sachs were cutting Fannie and Freddie out of the loop by securitizing loans and selling them directly to investors. Suddenly, Fannie and Freddie ran the risk of becoming obsolete and failing on their Congressional mandate. Another former senior executive at Fannie Mae was quoted as saying:

Everybody understood that we were now buying loans that we would have previously rejected, and that the models were telling us that we were charging way too little, but our mandate was to stay relevant and to serve low-income borrowers. So that's what we did.

With Congressional support, the sub-prime mortgage market ballooned from $160 billion in 2001 to $540 billion by 2004, a three fold increase in just four years.

Loose monetary policy, aggressive lending practices, speculative real estate investors, and financial weapons of mass destruction had now set the stage for biggest financial disaster in US history since the Great Depression. We'll explore the wild ride down from 2007 to today in the next and final installment of this series.


All quotes taken from The New York Times article entitled The Reckoning.


PART IV

The final episode of this series opens in summer of 2006 at the peak of the US housing markets. Consumers have been leaning on their home equity to finance their spending and drive economic growth. In addition, the advent of the credit default swaps have made risk a transferable and tradeable product. The perception that risk can be stripped out of an investment vehicle and transferred to another counter party has driven credit spreads (the difference between the cost of risky, corporate debt and the risk free US government debt) to historically low levels. Tight credit spreads have made it very cheap to borrow money and create leverage to amplify returns. But all that is about to change as the era of easy money and excessive leverage comes to a screeching halt.

The trigger that started the downward spiral known as the"credit crisis" was the deflating of the housing bubble. For over a decade, the average home price in the US had been rising at a breakneck pace. As previously discussed, this rise was driven primarily from a sharp increase in demand as speculators drove real estate prices to the moon. Eventually houses became too expensive and no type of exotic loan could put the average American family into the average American home. The housing market peaked and prices slowly started to come down as demand began to dry up. When the markets began to soften, the accessibility of exotic loans, which were built on the premise that home equity could be created through home value appreciation rather than principal payments, dried up. Around this same time, the teaser rate on the first major wave of ARMs (adjustable rate mortgages) expired and over extended home owners found it hard to make the floating rate payments or refinance with a classic fixed rate loan at a much higher rate. With little to no equity invested in their house, these same people stopped making payments and defaulted on their loans. This was the first domino to topple in a chain reaction that later grew into the current credit crisis.

The perpetual rise of the housing market was a cornerstone assumption behind many of the AAA rated securitized loans. It behooved rating agencies to assign AAA ratings to securitized loans in order to open them up to a wider audience of potential buyers (mainly pension funds and insurance companies which can't hold anything rated below AAA). In order to assign a securitized loan an AAA rating, certain assumptions have to be made about the underlying whole loans and the probability of each of those loans going into default. As long as housing prices continued to rise, equity would be created for the homeowner, which lowers the probability of default. In the rare instance where default does occur, the bank can then take over the property and recoup their investment by selling the appreciated asset. But everything isn't quite as rosy if the housing market where to suddenly stop rising and actually start falling. Under this scenario, equity is being destroyed and the probability of default is much, much higher. When the bank has to take over the house and sell it, they may not be able to recoup their investment as the value of the home is eroding.

The inability to collect payments and recoup principal greatly reduced the value of many securitized loans. Rating agencies, slashed their ratings on the loans forcing some buyers who could only hold the highest grade investments to sell their positions. Everyone started rushing for the door at the same time causing the securitized loan markets to freeze up. The affect was felt beyond just mortgage backed securities (MBS) as the markets for securitized student, auto, and credit card loans froze up as well. There were no buyers for the glut of securitized loans that had been created over the past two decades.

Obviously, the first sector to feel the pain of the withering securitization market was the financial industry, which created, traded, and held the vast majority of these products. The basic business model in banking (borrow at a low rate, lend at a higher one) lends itself to a large amount of financial leverage. One way to think about financial leverage is the ratio of debt to equity a company utilizes. For example, let's say a company has $100 million in assets and $90 million in debt. The equity is simply the assets minus the debt or $10 million dollars in this example, so the ratio of debt to equity is 9 (90/10), which is very high by any industry standard. Now imagine that the assets had to be repriced and it was determined that they were really only worth $90 million. This would wipe out the equity and also upset the debt holders as the assets of the company would most likely have been used as collateral to secure the debt. This is exactly what happened to banks and other institutions that held securitized loans and were forced to take write-downs on their value.

As asset values dropped, creditors (banks who lend other banks money) started demanding more collateral for the funds they lent out where securitized loans had been used as collateral. This created a huge problem for institutions that didn't have cash on hand as they were forced to sell the securitized loans in order to raise cash, which pushed the value of the loans down even further, creating another collateral call, and starting the snowball esk cycle all over again. It wasn't long until the equity capital was totally destroyed along with investor's confidence. All the write-downs and general lack of confidence led to several modern day "bank runs" as investors bolted for the door sending stock prices plummeting (which further perpetuated the general lack of confidence) and customers yanked away their funding/business.

Investment banks were the first to feel the heat as they utilized the highest degree of leverage (over 20x in some cases) and didn't have a deposit base (people like you and me who keep checking and savings accounts at their local bank) as a cash backstop. The first investment bank to go belly up was Bear Stearns in March of 2008 when the Fed saved it from bankruptcy by forcing an unholy union with JP Morgan. The buyout of Bear Sterns bought the market some time, but eventually others followed suit. Just six months later, Lehman Brothers filed for bankruptcy when they were unable to find a suitor to buy them out. The bankruptcy of a prominent, 150 year old investment bank like Lehman Brothers sent shock waves throughout the investment industry as companies quickly realized that they could be the next to fail. Just a couple days after Lehman's bankruptcy, Merrill Lynch, another prominent investment bank, announced it was being acquired by Bank of America.

The pain of the market deleveraging was not isolated to the investment banking community. Retail banks that were heavily invested in mortgage backed securities were the next "shoe to drop." Several retail banks failed and either had to be taken over by the FDIC or sold off to other banks including the largest bank failure in US history, Washington Mutual. In addition to retail banks, the primary originators of securitized loans, Fannie Mae and Freddie Mac, had to finally be taken over by the US government after several failed attempts by the Fed to keep them solvent. If you remember back to the first post in this series, Freddie and Fannie were the primary originators of securitized loans and guaranteed hundreds of billions of dollars in mortgage backed securities. When these securitized loans dropped below investment grade, Fannie and Freddie were on the hook to make their investors whole. Unable to meet these demands, the only option was to declare bankruptcy sending a massive wave of write downs throughout the market, which in turn would lead to more bankruptcies or be taken over the US government in a tax payer funded bailout. With these two options, the Fed chose the later of the two evils and brought both of the mortgage giants in house.

The "fun" didn't stop there. Remember back to the second post in this series when we studied the birth and rise of the credit default swap (CDS). These contracts could be used to hedge exposure to certain events (e.g. reducing the risk of an investment defaulting or counter parties going bankrupt) or just to bet on the underlying event occurring. As securitized loans dropped below investment grade (the common event that triggers the collection on the corresponding CDS) and banks went bankrupt, investors holding CDSs on these events looked to collect on their contracts. The largest writer (seller) of CDSs was AIG who quickly realized that their "mouth was writing checks that their butt couldn't cash." To quote the author of the Fooled by Randomness and The Black Swan, Nassim Taleb, the CDS contracts were like "buying insurance on the Titanic from someone on the Titanic." Faced with the same options as Fannie & Freddie (massive market meltdown or bailout), the Fed again decided to put taxpayers on the hook by extending AIG a loan and taking a significant ownership stake in the company. Since the initial bailout, both the amount of the loan and percentage ownership have increased as AIG has continued to bleed red ink.

With banks and other financial firms going bankrupt or being taken over by the US government on a regular basis, the surviving banks "hunkered down" and tighten up their lending practices. At one point in early October, the global credit market was said to be frozen as banks were hording cash in fear that they might be the next to fail. The freezing of the credit markets was the final punch that brought Wall Street's pain to Main Street. Think of credit as the oil that lubricates the engine that is the global economy. Without a line of credit, companies have a very difficult time balancing their cash inflows and outflows on a daily basis (e.g. purchasing inventory, making payroll, etc...). As the cost of credit/debt increases, the profitability of a company that utilized that credit decreases. The combination of increasing costs and decreasing demand forced companies to cut costs by downsizing their workforce.

All of these factors have culminated in rising unemployment, the US stock market dropping close to 50% from it's 2007 high, and a global wide recession for the first time in modern day history (who knew that the US homeowner had so much power). So that is the long and short behind "the mess in the US" (which should more apply be named "The Mess Around the World" but it just doesn't roll of the tongue quite as nicely) in a rather large and bloated nutshell. The ending of this sad saga has yet to be written, but it is safe to say that the combination of complex financial innovation (securitized loans and credit default swaps) and greed (excessive leverage and market bubbles) led to the largest market meltdown in US history since the Great Depression. To be fair, innovation and creativity are what make America great and set it apart from the rest of the world and "greed for life, for money, for love, [and] knowledge has marked the upward surge of mankind." Put another way by a fellow Franco follower, complaining about the greed on Wall Street is "like complaining about too much testosterone in a football locker room or too much makeup at a beauty pageant." And with that final thought we put this series to rest.