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Investment letter – April 20, 2010
The majority of the financial ‘experts’ in the world did not see the credit crisis coming, including the Federal Reserve, SEC, numerous Congressional committees with financial and regulatory oversight, and certainly not the heads of the financial institutions that failed or required a federal government orchestrated ‘bailout’ to stay in business. To simply chalk it up as a Black Swan event is an intellectual copout that concedes an unacceptable level of helplessness in the face of less than mysterious forces. Labeling the largest financial crisis in history as a Black Swan event also provides a degree of absolution to those responsible, who were either blinded by ideology or straightforward greed. The millions of honest hard working people who lost their job deserve better, as do the millions more who work hard and play by the rules. Politicians from both parties and anyone else looking for just one cause for the crisis are missing the bigger picture, and more likely trying to point a finger away from their own contribution. A crisis of this magnitude was not the result of one dynamic. It was a team effort with many contributing players.
With an election coming in November, Congress is highly motivated to show American voters it is enacting legislation in the Financial Regulation Reform bill that will insure a crisis of this magnitude never befalls this country again. Unfortunately, I have yet to hear anyone address what was undoubtedly the most important factor in the crisis. The following chart explains why the crisis was so big, and a fifth grade math student can understand it, and that is not an exaggeration!
Between 1965 and 2000, the median home price was consistently around 3 times median income. During this 35 year period, the U.S. economy experienced a recession in 1969-1970, 1973-1974, 1981-1982, and 1990. Home prices are very sensitive to interest rates, and between 1965 and 2000, interest rates fluctuated wildly. The Federal funds rate jumped from 4.5% in 1965 to 21% in 1981, before working its way down to 5.0% in 2000. The 30-year mortgage rate rose from under 6% in 1965 to almost 18% (not a typo) in 1981, before dropping to 7% in 2000. It is remarkable that this relationship between median home prices and median income was maintained, despite extreme fluctuations in interest rates and periods of economic recession. It begs the question, How was this possible?
This relationship was maintained because between 1965 and 2000, home buyers were not allowed to buy a home if their mortgage payment was more than 33% of their verified income. The reciprocal of 33% is 3 to 1, which is why median home prices held very close to the 3 to 1 multiple of median income. However, between 2000 and mid 2006, median home prices rose to 4.6 times median income. This was made possible because lending standards were trashed, and prospective home buyers could purchase a home with no money down and without verifying their income. The lax lending standards created an incremental increase in demand that pushed low end home prices up. This allowed the owners of those low end homes to trade up, which set off a chain reaction of trade up demand that pushed mid and upper end prices higher. Some blame the crisis on the Federal Reserve for keeping rates at 1% for too long. The Federal funds rate was 1% between June 2003 and June 2004. After that, the Federal Reserve increased the funds rate by .25% at each of the next 16 meetings. It is almost preposterous to suggest the entire crisis was the result of Fed interest rate policy, after considering the impact lower lending standards had on increasing demand from weak borrowers.
In effort to allow more low income Americans to realize the dream of owning a home, members of Congress pushed Fannie Mae and Freddie Mac into lowering their lending standards. Both firms received lending quotas from the Department of Housing and Urban Development (HUD), and both firms felt obligated to meet or exceed those quotes, which they did. In testimony before the Angelides Commission, which is investigating the financial crisis, Daniel Mudd, former Freddie Mac CEO, said, their ‘standards slipped’, as they ‘were balancing against our housing HUD housing goals.” Former Federal Housing Finance Agency Director James Lockhart testified that Fannie and Freddie “would have incurred the wrath of Congress if they missed those HUD goals.” In 2008, Fannie Mae and Freddie Mac held 56.8% of the $12 trillion in outstanding mortgages. Did lowering their lending standards at the behest of Congress contribute to the increase in home values and subsequent crisis? Absolutely. Fannie Mae and Freddie Mac have been taken over by the U.S. government, and the taxpayers will have to make good on their combined losses of at least $400 billion. It’s also worth noting that between 1988 and 2007, Fannie and Freddie made almost $200 million in campaign contributions to Congress. The three largest recipients in the Senate were Christopher Dodd, John Kerry, and Barack Obama.
But to suggest that Fannie and Freddie were the cause of the crisis is an exaggeration, since sub-prime lending was a big deal in the private sector too. Independent nonbank mortgage brokers originate almost 40% of all mortgages. Since 2007 more than 300 have failed, including Ameriquest, New Century Financial Corp., and Ownit, while Countrywide Financial was acquired by Bank of America. Washington Mutual, the largest bank failure in U.S history, was a big player in sub-prime lending, and according to the Senate’s Permanent Subcommittee on Investigations rewarded loan officers and processors based on how many mortgages they could churn out, and awarded members of the President’s Club with lavish all-expense paid trips to Hawaii and the Caribbean. The emphasis was on quantity, not quality. Lending standards? We don’t need no stinking lending standards! After reviewing more than 50 million documents, the Subcommittee determined that borrowers were steered into sub-prime mortgages, even though they qualified for prime loans, which would have cost the borrower less. But Washington Mutual’s brokers made more in commissions on sub-prime loans. The Subcommittee also found that the bank knowingly included fraudulent loans in mortgage securities sold to investors. I have no doubt that these same practices were duplicated at many of the firms that failed, and some that were bailed out.
Twenty-five years ago, bank lending was largely dictated by the amount of loans a bank had on its balance sheet relative to its capital base. If a bank could make a loan, and then sell it to someone else, the bank could make more loans, without increasing its capital base or loan reserves. Although the bank would make less money on each loan it didn’t hold onto, it could increase earnings, by significantly increasing loan volume. The process of moving mortgage loans off bank balance sheets was initially facilitated by Fannie Mae in the early 1980’s. Fannie Mae would buy mortgages from banks all over the country, package them together, and sell them to Wall Street and institutional investors. This was fairly easy to do, since lending standards were fairly strict and uniform, and most mortgages were ‘conventional’.
There are many advantages to the ‘securitization’ of mortgages. Borrowers get lower mortgage rates, due to competition. Pension funds and insurance companies are able to increase their investment returns, since mortgage backed securities offer a higher return than Treasury bonds. The success with mortgage securitization has led to the securitization of car loans, credit card receivables, and numerous other assets. This has increased the flow of credit into many sectors of the economy, and until the music stopped in 2007, kept the economy humming. Between 1982 and 2007, our economy was in recession only 16 months. In the 25 years prior to 1982, there were 64 months of recession. A growing economy generates more jobs, a higher standard of living, and a tide that lifts the fortunes of most Americans.
The decline in lending standards however exposed a fatal flaw in the securitization of mortgages. If there are no negative financial consequences when a prospective home buyer can purchase a home with no money down, a mortgage broker can help a prospective homebuyer directly or indirectly falsify data, and a lending institution doesn’t have to maintain lending standards if they know they’re going to bundle the ‘bad’ loans and sell them to be securitized, an open season for fraud and abuse is created. Everyone involved got to make a lot of money, as they shoveled the bad loans to unsuspecting buyers of mortgage backed securities. This type of fraud was allowed to develop over a period of years, while the Federal Reserve, Federal Deposit Insurance Corporation, and Office of Thrift Supervision did nothing.
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