The Financial Crisis, Part I

Hard to remember a bigger news story, and the stories about it tend to come in liberal and conservative flavors, and grow in the telling.

The liberal argument, as I understand it, is that this is a case of mass predatory lending and greed, with Wall Street sucking the life out of Main Street (and in particular, the poorer end of Main Street) for short-term gain. There is also talk of deregulation leading to this, though never any specifics about what deregulation was to blame. You'd think that after two weeks they could cite a bill or an Executive Order or some published relaxation of SEC or federal lending rules to justify this position, but I have yet to see a single citation.

The conservative position is pretty well laid-out in a video called "Burning Down the House: What Caused the Economic Crisis?", which was up on YouTube until Warner Brothers made a copyright claim against some of the music used in the video and YouTube took it down. That is fishy in and of itself (it's a pretty good bit of viral video), but I will summarize until I can find another copy of it.

In 1977, the Carter Administration and Congress passed the Community Reinvestment Act, a law designed to keep banks from only lending to people in certain neighborhoods and with certain credit scores. This process is called "red-lining", and the implication was than banks were only giving loans to white people in good neighborhoods.

In 1995, the Clinton Administration updated the CRA with teeth. Federal bank examiners would look at a spreadsheet of loans given by a bank, and if sufficient geographic and racial diversity was not present the bank examiners would penalize the bank. That the creditworthiness of borrowers was taken into account was not a significant factor, in essence the feds put a gun to the head of banks and told them to loan money to people that were credit risks. The other place where teeth were added, and those are the teeth that are the real issue this year and last, is that the government provided that these credit-risk loans, called 'subprime loans' (heard that term recently) could be purchased from the banks and resold by the two Government Sponsored Entities, Fannie Mae and Freddie Mac.

See, mortgages aren't just loans to you. Every loan to you is in effect a bond to someone else -- your loan is their purchase, the interest you pay is the interest they earn for their investment in your property. The collateral for the mortgage, and the bond is the value of your house. Something Fannie Mae and Freddie Mac did to make more money available for mortgage lending was to buy loans from banks, package them up into millions of dollars worth of loans, and then resell them to investors. Once the loan is sold, your bank gets its capital back and then it can loan money to someone else to buy another home. The whole thing depends on two factors: one, that a home is worth its sale price, and two, that the person with the mortgage can make the payments of interest and capital. Losing either of those things would be bad.

The Wall Street Journal has a great Flash presentation on how these Residential Mortgage-Backed Securities became the current bane of Wall Street: the Collateralized Debt Obligation. I strongly advise you to look at these pages and step through the way that mortgages were turned into assets, which are now less asset-y than they were, and which is the source of the problem. Some of the smartest people in finance in the world designed the bundling of RMBS to reduce risk, and then the CDOs to gather tranches from multiple RMBSs to further reduce risk, and then covered themselves with credit-default swaps (another financial derivative that hammered AIG into near-insolvency) to reduce risk. Do you believe they adequately assessed the risk? Me neither.

OK, back to the Conservative Case. Barack Obama, fresh out of law school at Harvard, took a job at a law firm in Chicago. One of the cases he won as a lawyer was Buycks-Roberson vs. Citibank, a 1994 case representing black plaintiffs who sued Citibank for "redlining" and not loaning enough to black applicants, in violation of the CRA. There was not only civil litigation against banks for violating the CRA, there was political pressure on Fannie Mae & Freddie Mac to take more subprime loans.

The goal of the CRA, and of the Congressional protectors of Fannie Mae & Freddie Mac, was noble. The goal was to increase home ownership among the poor, which I am completely in favor of assuming they can afford to buy and keep up their homes. By taking on and securitizing subprime loans, Fannie and Freddie were able to do this...until recently.

Fannie & Freddie had problems of their own in the 1990s, though. They had major accounting problems that were used to artificially inflate their stock price. They paid their executives tens of millions of dollars, just like Wall Street firms. They were badly undercapitalized, meaning they did not have cash on hand to back the loans they sold. Any normal company would have been bankrupt long before now, but as Government Sponsored Entities (GSEs) created for the purpose of making housing more affordable, they were able to pull off selling subprime mortgages with a wink and a nod at Uncle Sam, who they implied was good for it.

Fannie & Freddie did make a lot of money on fees by buying and reselling loans, and they spent that money on political action. The two people they spent the most on in the last 20 years were Senator Christopher Dodd (D-CT), the chairman of the Senate Banking Committee, and Rep. Barney Frank (D-MA), the chairman of the House Financial Services Committee. These were not idle investements, multiple times during the Bush Administration more oversight of Fannie & Freddie were proposed and then shot down in Congress. This included a bill John McCain cosponsored in 2005, which did not make it out of the Banking Committee.

The member of Congress who was #3 in donations from Fannie & Freddie was Sen. Barack Obama. What makes this all the more incredible is that Dodd & Frank's totals were obtained over 20 years. Obama's was obtained in just four years in the Senate. One of the leading banks to participate in making and selling subprime loans was the late and unlamented Countrywide, who not only made subprime loans to people not creditworthy, they made sweetheart loans to members of Congress under what was called the Friends of Angelo program, named after now-disgraced Countrywide CEO Angelo Mozilo.

Just so we're clear, the guy in charge of oversight of the Senate Banking Commitee a) got the most money from Fannie Mae & Freddie Mac, two of the companies he was overseeing, and b) got a great deal on a mortgage from one the companies that did the most business with Fannie and Freddie. And one candidate for President (Barack Obama) was #3 on the money list from Fannie & Freddie after less than one term in the Senate.

Earlier this summer, Fannie & Freddie were taken over by the federal government as insolvent.

The conservative case comes down to this: the free market was not free, it was used for social engineering purposes. The normal checks and balances on making loans to credit risks were overrun by regulation (not deregulation) and then exacerbated by Fannie Mae and Freddie Mac buying those loans and reselling them to others. The predatory lending was encouraged by the government, not prevented by it, over the space of 30 years.

My position is that the conservative case is close to reality, but not all of reality. Yes, the CRA contributed to hundreds of billions of dollars in bad loans being issued, but the fact of the matter is that many of the banks that failed have done so in part because rather than reselling their subprime loans, they kept them on the books. Why? Because subprime loans command greater interest due to greater risk. Why keep your 5% loans to creditworthy people and sell off the 8-9% loans? Hold on to some of those subprime loans and count on rising home values to make up the difference. This worked until the rising home prices stopped rising due to increased interest rates and oil prices bit into the family budgets. The banks that did this are already has-beens: Countrywide, Great Western, Indy Mac, Bear Stearns.

The banks that are suffering now are suffering in part because they have as assets things like CDO shares and RMBS pools that they have no idea how to value. If more and more mortgage-borrowers default, then the CDOs and RMBSs will decline in value. With home sales dropping and home prices falling, there isn't a really good way to value those things, so what liquid capital these financial institutions have they must hold onto to maintain capital limits.

Some of the now-extinct banks likely bought CDOs and RMBSs on margin -- they paid $10 million and borrowed $90 million to buy $100 million in CDO shares or RMBSs, and with those now declining in value and income the people who loaned the banks money now want their $90 million back. It doesn't take too many deals like that to destroy all of a financial institution's good capital.

It gets worse if the banks and trading houses were also participating in a credit-default swap with another institution. This is in essence an insurance policy for a CDO transaction or other transaction. Company A agrees to pay Company B if Company B's investment goes belly-up. The thinking up until recently was apparently that this was easy money as long as what was being purchased was residential mortgages, worst-case scenario in a market with rising home prices was that the home would be resold for more than the mortgage. When home prices fell and Company B's investment in CDOs went south, Company A was on the hook for the deal. This is how AIG ended up becoming a fiscal ward of the state. There is an estimated $45 trillion in credit-default swap obligations floating around right now. The US has a $13 trillion economy, if that tells you how big this derivative market got.

Yes, there was greed on Wall Street. There is always greed on Wall Street, and this time more than just the trading houses got in on it. The bond raters like Moody's and Standard & Poor's and Fitch vastly overrated the subprime mortgages. The mortgage companies found clients and got them together with banks to make deals that, in retrospect, look stupid. And there was definitely greed on Main Street -- buying houses for well more than 3x your annual income, the usual rule-of-thumb for mortgages. Shows on TV like "Flip this House", and there are still advertisements for programs to "Get rich in real estate!" People at every level were greedy, and now even us non-greedy people get to pay for it.

Ultimately, the whole system forgot the basic rule of economics: There Ain't No Such Thing As A Free Lunch, also known as TANSTAFFL. This law is as inviolate as the Second Law of Thermodynamics. I don't need to listen to the description of a perpetual motion machine, because they don't work. Just because a financial guru with a PhD in mathematics can show formulas that prove that a free lunch can make more food by gathering free lunches and reselling the components of the free lunch to investors in sandwiches and apples and cookies does not mean there is, in actuality, a free lunch to be had.

America has lived beyond its means as a nation for years. And I believe that time is coming to an end. The shape of things to come will be interesting, at the least.

Financial+Crisis