Posts filed under “Really, really bad calls”
I wanted to address a glaring error in a David Leonhardt NYT Sunday Magazine article, titled Heading Off the Next Financial Crisis,
In the column, Leonhardt wrote:
“But there was a fatal flaw in the new system. The banks’ new competitors received scant oversight. They were not directly bound by Roosevelt’s restrictions. “We had this entire system of outside banks that had no meaningful constraints on capital and leverage,” Geithner says. Investment banks like Lehman Brothers were able to make big profits in part by leveraging themselves more than traditional banks. To use the down-payment analogy again, it was as if Lehman were allowed to put down only 3 percent of a house’s purchase price while traditional banks were still making larger down payments. When the house’s value then rose by just 3 percent, Lehman doubled its investment. A.I.G., similarly, created a highly leveraged derivatives business that regulators essentially ignored…
The deregulation of the last few decades has come in for a lot of blame for the current financial crisis. It deserves some blame, too. If Citigroup and Bank of America were still operating under the New Deal rules, they might not have flirted with bankruptcy. But take a minute to think about which firms had the biggest problems. They were the shadow banks: stand-alone investment banks like Lehman, Bear Stearns and Merrill Lynch; and other firms, like A.I.G., that were not banks at all. They were never fully covered by the New Deal regulation, and they were not the ones most affected by the deregulation.” (emphasis added).
This is not precisely right.
And as applied to AIG, it is absolutely, totally wrong.
Thanks to the The Commodity Futures Modernization Act of 2000 (CFMA), the universe of structured derivatives were completely exempt from ALL regulation. Whether it was Collateralized Debt Obligations (CDOs) or Credit Default Swaps (CDSs), the CFMA put them into the world of shadow banking.
How? The CFMA mandated it. No supervision was allowed, no reserve requirements for potential future payouts were mandated, no exchange listing requirements were put into effect, all capital minimums were legally ignored, there was no required disclosures of counter-parties. Derivatives were treated differently from every other financial asset — stocks, bonds, options, futures. They were uniquely unregulated.
Indeed, even state insurance regulators were prevented from oversight — including normal reserve requirements. That was how AIG Financial Products was able to ramp up their derivative exposure to more than three trillion dollars. This was directly due to radical deregulation.
Even the most basic reserves would have kept their derivative exposure to much more modest numbers. With absolutely zero capital requirements, AIG FP went wild. Tom Savage, the president of FP, summed up what the lack of reserve requirements meant to the firm: “The models suggested that the risk was so remote that the fees were almost free money. Just put it on your books and enjoy.”
To the tune of $3 trillion dollars.
All in all, this wasn’t so much a case of Washington DC failing to keep up with Wall Street, rather, it was a case of DC actively granting what Wall Street (Enron, AIG and other derivative traders) wanted — precisely zero oversight.
Hence, it was deregulation that made the AIG disaster possible.
As to the investment houses (Bear, LEH, MER, etc.), all you need to do is look one step upstream in the securitized mortgage process. There, you see the impact of the radical deregulation mindset.
Consider the mass of subprime loans that the investment houses were securitizing. The majority of these came from non-bank lenders. These were the firms that Fed Chair Alan Greenspan described as innovators.
He elected not to regulate them. I called this “Nonfeasance” in Bailout Nation. No lending standards: Zero income checks, ignore the debt load, eliminate LTV, even fail to do a simple simple FICO credit check. Just a lend-to-anyone-then-sell-to-securitizers business model.
Securitization wasn’t the problem, it was simply Garbage in, Garbage out. Had Greenspan required nonbank lenders to maintain normal lending standards (As was his official duty), much of the crisis could have been avoided. At the very least, all of the subprime related loans, derivatives, and default swaps built on top of these garbage mortgages would have been dramatically reduced.
Bottom line: Radical Deregulation is what allowed most of the worst actions to take place. This wasn’t a case of DC failing to keep up with Wall Street — its more accurate to observe that DC rolled over for Wall Street, and gave the Street precisely what it asked for.
Heading Off the Next Financial Crisis
NYT, March 22, 2010
In the Sunday NYT, Greg Mankiw posits the following: • Governments cannot Regulate. Proof? Radical Deregulation failed… • “I’m not saying Fannie Mae was THE cause of the collapse — but they were a major causal factor.” • We have no clue why Economists suck — but they just do. You can read the rest…Read More
The Sunday NYT catches up with what many others who watch banks have known for a long time: John C. Dugan, the former banking lobbyist and Bush appointee to the job of Comptroller of the Currency, is a tool. Dugan’s contribution to the collapse of the United States began way back in 1989. Congress had…Read More
I have been dismayed about the latest actions out of Washington and Wall Street. The banks are now pushing all manner of mortgage mods and foreclosure abatements. These are little more than “extend & pretend” measures, designed to put off the day of reckoning. They are not only ineffective, they are counter-productive. They reward the reckless and punish the responsible, and create a moral hazard. Worse yet, they penalize middle America for the sake of giant Wall Street banks.
It may sound counter-intuitive, but the best thing for the nation (but not necessarily the banks) is to allow the foreclosure process to proceed unimpeded. We need more, not less foreclosures.
How did we get to this bizarre place in history? A brief recap of our story so far:
It started with the ultra-low rates of 2001-04. It was aided and abetted by an abdication of traditional lending standards, at first by non-bank lenders, but eventually, by nearly all. The Lend-to-Sell-to-Securitizer NonBanks pushed lending standards ever lower to the point of non-existence. This increased the pool of potential mortgage buyers, credit worthiness be damned.
The net result of all this was a credit bubble. I estimate that making mortgage requirements disappear brought between 10 and 20 million marginal new home buyers into the real estate market during the 2,000s decade. This drove prices to unsustainable levels, leading to a huge boom and eventual bust cycle in housing.
Prices have fallen about 30% nationally from the 2005-06 housing peak. As the artificial demand created by free money and an accompanying gold rush mentality disappeared, the housing market collapsed.
Despite this, even down 30% or so, prices still remain elevated by historical metrics. The net result has been 5 million foreclosures and counting. One in four “Home-owers” are underwater — meaning, they owe more on their mortgages than their houses are worth. There are another 3-5 million likely foreclosures coming over the next 5+ years.
The net results of the credit bubble are as follows:
1) An enormous number of families living in homes they cannot afford.
2) Bank balance sheets laden with current bad loans and lots of potential future defaulting loans.
3) Real Estate Sales, despite being propped up with historic low mortgage rates and tax purchase credits, are continuing to slide.
4) A weak overall economy with a very slow, soft recovery.
Whether a function of populist politics or bad economics, the proposals so far appear to address items one and three. But upon closer examination, they do nothing of the kind. In fact, they are actually gaming the system to help issue two — the bad loans the banks are carrying.
Even worse, they are making issue #4 — the economy — increasingly problematic.
We should allow the real estate market to experience a healthy price normalization process. Even though home prices have fallen dramatically, they have yet to reach their historical means relative to income or the cost of renting. This is to say nothing of the usual careening past the median towards under-valuation that typically follows a massive mis-allocation of capital.
We own a home, and have a vacation property. Rooting for falling prices is “talking against my own book.”
Why is it so beneficial to allow foreclosures to proceed unimpeded? Consider the following benefits of foreclosure:
• Increasing Economic Activity: The areas of the country with the greatest foreclosure rates have seen the biggest increase in real estate activity. Look at California and Florida — they have seen enormous upticks in sales versus the lower foreclosure states.
The process moves real estate holdings from weak hands to stronger ones. When someone purchases a home they actually can afford, they end up spending quite a bit of money on additional goods and services. They do renovations, hire contractors, make durable goods purchases, buy cars. They do lawn work, plant gardens, paint and repair. They even hire baby sitters, go out to diner and movies, they spend money in the local community.
The people who are hanging on by their fingernails, however, do almost none of these things. They pay a vastly disproportionate amount of their incomes to service their mortgages. This is not productive economic activity.
• Helping Families: Foreclosures, wrenching thought hey may be, move over-stretched families into housing they can afford. They avoid a steady stream of all manner of excess fees. The banks squeeze whatever they can from delinquent homeowners, who end up futilely tossing $1000s of dollars down the drain.
Worse, the HAMP programs have been totally ineffective in keeping families in their homes. The vast majority ultimately default anyway. More fees paid, more debt accrued, for nothing. The last thing these families need is a banking fee orgy, before they ultimate lose the house anyway.
The HAMP programs have been an enormous taxpayer subsidized boondoggle for the banks, however.
• Punishing the Prudent: The boom and bust saw irresponsible and reckless behavior by lenders and home buyers alike. They overused leverage, disregarded risk, ignored history. Having the taxpayers subsidize this behavior presents a moral hazard.
Worse than that, it punishes the people who behaved prudent and responsibly. Those who refused to buy a home they could not afford, chose not to over-extend themselves, and have been saving for a down payment are the net losers in this.
By working so feverishly to artificially reduce foreclosures and prop up home prices, we punish the first time home buyer, the newlyweds, the savers who want to buy a house they can actually afford.
The net result of all these programs and subsidies for recklessness is that we prevent home prices from normalizing. The people who are punished the most are the group that was not reckless, speculative or foolish.
• Rewarding Bad Banks: Despite the helping families rhetoric, it is not what these mods are about. The various foreclosure abatements, mortgage mods and capital write-downs are little more than a game of kick the can down the road. All of these programs are part of a broad “Extend & Pretend” mind set. They are an extension of the FASB 157 rule changes that allows banks to hide their bad loans.
The entire set of proposals canbe described as “Whats good for the banks is good for America.” Only they are not. The various foreclosure programs are essentially a way the banks don’t have to take their write offs now. Avoid the hangover, have another shot of tequila, push the pain of into the future, regardless of economic cost.
Were the banks required to report their mortgages accurately and/or write them down, they would be revealed as insolvent.
Now we get to the ugly Truth: The mortgage mods and foreclosure abatement programs are really all about propping up insolvent banking institutions on the taxpayer dollar and at the expense of the middle class. These programs are another losing round of helping Wall Street at the expense of Main Street. It is the worst kind of trickle down economics.
Herbert Spencer wrote, “The ultimate result of shielding men from the effects of folly is to fill the world with fools.” We have done precisely that.
At the recent Make Markets Be Markets conference, I got to ask a questions of the esteemed panel — Joseph Sitglitz, George Soros, Jim Chanos, Simon Johnson, Elizabeth Warren, etc. That question was simply this: Why do Bad Ideas seems to persist for so long? How do certain concepts hang around, long after they have…Read More
Category: Really, really bad calls
On Wednesday, I posted my disgust with the kindle fanboys trashing of Michael Lewis’ new book, The Big Short. I was surprised to hear from a number of literary agents who wrote to thank me for that. They have apparently been having all manner of issues with Amazon reviewers over the years, and the kindle…Read More
The WSJ is reporting that back in 2003, the SEC tried to remove the restrictions on compromised security analysts that tried to prevent them from whoring out recommendations for banking business. Similar to the prostitution of the ratings agencies, the SEC somehow thought it was okay for iBanks to fuck their stock buying investors, just…Read More
I mentioned earlier how much I liked the 60 Minutes piece with Michael Lewis. Janet Tavakoli called foul this morning on Lewis assertions, pointing to a Bloomberg column he wrote in 2007, titled “Davos Is for Wimps, Ninnies, Pointless Skeptics.” Tavakoli specifically points to this paragraph: “None of them seemed to understand that when you…Read More
“People are starving for yield because rates are at zero. They’re taking more risk than they think.” -Paul Tramontano, Constellation Wealth Advisors, > One of the factors that caused the great credit crisis to spread far and wide was the “reach for yield.” This is one of the most expensive ways a fixed income investor…Read More