10 steps to economic disaster:
Banks, mortgages, and the financial bubble
By Dr. John F. Sase
with Gerard J. Senick
“In the fall of 2008, America suffered a devastating economic assault. It left deep wounds: Millions lost their jobs; millions lost their homes. Good businesses shut down. Financial markets froze, the stock market plummeted, and once-valuable securities turned worthless. Storied financial firms teetered on the edge or went under. The contagion spread worldwide. And, in October 2008, American taxpayers were hit with a $700 billion bailout of Wall Street.”
–Senator Carl Levin (D-MI), Opening Statement, U.S. Senate Permanent Subcommittee on Investigations Hearing on Wall Street and the Financial Crisis: The Role of High Risk Home Loans, 13 April 2010.
As this column was being written, the bipartisan U.S. Senate Permanent Subcommittee on Investigations was continuing its hearings. This series of hearings resulted from an ongoing examination that began in November 2008. This inquiry is devoted to finding some of the causes and consequences of this major economic crisis that continues to ripple through the U.S. and global economies.
The Subcommittee’s approach to the problem has been to develop detailed case studies that examine each stage of this assault on our financial system. These studies cast a cold, harsh light on the core issues of our financial crisis. In the investigative process, the Subcommittee conducted more than one hundred lengthy interviews and depositions; consulted with dozens of experts from government, academia, and the private sector in respect to a raft of banking securities, financial, and legal issues; and collected and reviewed millions of pages of pertinent documents.
The Subcommittee hearings examine the roles of various large, influential banks and Wall Street investment and related firms. The process will focus upon the financial community’s use of complex, non-transparent instruments to transact business. In addition, the process will show how a rush toward high-risk instruments displaced the staid policy of making low-risk investments, how financial engineers got derailed in their securitizations, and how “castle-in-the air” investments overtook those of sound foundation in the real economy. Furthermore, the Subcommittee will explore the overarching problem of how the American investment community slipped into wild gambling as it pitted American businesses against one another through credit-default swaps that have led to the demise of many solid companies. All of these misbehaviors continued while regulators, credit-rating agencies, and other financial watchdogs failed to rein in the “insanity of crowds.”
“How I Did It” by Baron Victor von Frankenstein
(A Book in the Baron’s Private Library in the film “Young Frankenstein,” directed by Mel Brooks, Gruskoff/Venture Films, 1974)
When they wanted to purchase a home, families relied upon their local banks or mortgage companies until the early 1970s. In the loan-application process, those of us who purchased homes during that time provided extensive financial information, made significant down-payments, and contracted for fifteen- to thirty-year mortgages that these companies held and serviced until we paid off our mortgages many years later. However, over the past few decades, this method of home financing has changed. It has led to the financial quagmire in which we as a nation now find ourselves.
To simplify this complex evolution toward disaster, let us frame the chain of sequential and concurrent events. To this end, let us consider “The Ten Steps to Economic Disaster,” presented more as a Julia Child recipe than a step-by-step self-help program. As we disembowel the American economy, let us not forget to “Save the liver!” Bon appétit!
Step 1) Repeal regulations on banking and other financial institutions. These regulations were put into place after the bank failures of 1933. (Note: the historic “bank runs” started in Detroit during January of that year). Therefore, Congress passed the Banking Act of 1933. This legislation was comprised of two separate laws, commonly known as the Glass-Steagall Act. This introduced a number of reforms in reaction to the collapse of a large portion of the American commercial banking system. The Act, which was intended to prevent such a calamity from ever happening again, included the separation of banks in respect to their business. Commercial saving and lending institutions were separated from investment banks. Hearings at the time revealed conflicts of interest and fraud in the securities activities of some banking institutions. As a result, a formidable barrier to the mixing of these activities was set up by the Glass-Steagall Act. Provisions that prohibit a bank holding company from owning other financial institutions were repealed on 12 November 1999 by the Gramm-Leach-Bliley Act.
The repeal of Glass-Steagall enabled commercial lenders such as Citigroup, the largest U.S. bank by assets at the time, to underwrite and trade instruments such as mortgage-backed securities, collateralized debt obligations, and the structured investment vehicles that purchased those securities. (Note: in December 2009, Senator John McCain (R-AZ) and Senator Maria Cantwell (D-WA) jointly proposed reenacting the Glass-Steagall Act in order to re-impose the separation of commercial and investment banking.)
Step 2) Allow large thrift institutions regulated by the Office of Thrift Supervision, one of the weaker Federal financial agencies, to change their business practices radically. For example, Washington Mutual Bank (WaMu) emerged as the nation’s largest thrift institution by catering to middle- and lower-income families and assisting less well-to-do purchasers in buying homes. However, in 2005, WaMu formalized a strategy to move its lending practices from low-risk to high-risk home loans based on the opportunity of “gain on sale” of these loans to outside investors. WaMu changed their focus away from the least profitable government-backed and other fixed loans to the Option Adjustable Rate Mortgage, Home Equity, and Subprime loans, the most profitable instruments.
Step 3) Allow mortgage lenders to charge high interest rates following initial low “teaser rates” and high loan-initiation fees for mortgage instruments that they plan to bundle and sell quickly. In other words, allow the incentives to earn substantially higher profits from originating and then disposing of mortgages than the lender could earn from holding and servicing the loans to maturity. In effect, the banks and mortgage companies face strong inducements to perform solely as agents and intermediaries in the orchestrated flow of mortgages upstream in the financial markets.
Step 4) Allow the financial sector to bundle together, to “package,” mortgage loans into securities that are easier to sell on the open market. Diversity in a portfolio helps to minimize risk. As with stock index funds, the common logic is that there is safety in numbers. This is because a bundle of mortgages, each with a different level of risk, will average out the risk to investors. Furthermore, a portfolio containing many separate mortgages is more marketable as one single unit. This form of packaging reduces transaction costs for institutional investors who are interested in moving large sums of money in the market at one time. It follows the old adage of “cheaper by the dozen.”
In the case of WaMu, the thrift institution originated and sold hundreds of billions of dollars of high-risk loans to Wall Street investors in return for sizeable fees. The obvious wisdom in the market emerged: one can generate substantially greater profits through fees from short-term involvement and resultant low risk than interest earned from long-term involvement of holding and servicing an instrument. The scene became one of “passing the hot potato.”
Step 5) Allow Wall Street investment banks and their brokers to develop increasingly complex securities backed by this torrent of high-risk mortgages and equity-based loans. These financial institutions followed the old wisdom that people like to eat sausages but prefer not to see how they are made. So, Wall Street developed new methods of securitization. Essentially, these methods allowed lenders to bundle together large numbers of home loans into a single loan pool. Next, developers calculated the amount of mortgage payments flowing from borrowers into that pool. They then formed a corporate shell or trust company to hold the loan pool. With that structure in place, these financial intermediaries used the resulting revenue streams to create new instruments, bonds known as Mortgage-backed Securities. In turn, the financial intermediaries sold these bonds to hungry investors.
In addition to developing these loan pools and designing some highly complex securities, the intermediaries marketed the securities to large institutional investors. These include pension funds, insurance companies, municipalities, university endowments, and the loosely regulated hedge funds that fell below the radar of the Security and Exchange Commission (SEC). Like the Chicago Sanitary and Ship Canal, these securitization activities reversed the flow of capital moving to housing markets. This resulted in a pooling of these securities, which had become ends in themselves. Rather than serving Main Street, home mortgages transformed into products for Wall Street traders who sought increasing volumes of these securities in order to generate fees for their companies and bonuses for themselves. However, in order to increase the flow volume, traders demanded more and more securities and, as a result, the mortgages that backed these securities.
Step 6) Allow banks to originate mortgages to the large waiting pool of lesser-qualified, high-risk borrowers who wanted their own piece of the American Dream of home ownership. As with any other corporation working under the constraint of their Primary Fiduciary Responsibility, banks acted on the obligation of maximizing returns for their stockholders. However, bank officers generally enjoy the benefit that flows from serving as both an employee who can earn increasing salaries and bonuses as well as increased wealth through the stock in their firms that they hold.
Therefore, high-risk, highly liquid home loans appealed to mortgage bankers because of the higher fees that subprime mortgages produced in comparison to the more staid low-risk loans. Therefore, in the market climate of rapidly rising demand that precedes the bursting of all financial bubbles, these high-interest subprime loans appealed to investors like iron pyrite-fool’s gold appeals to prospectors. Those intermediaries and investors who could recognize the pyrite quality bought the subprime-mortgage-based securities quickly and sold them profitably to the legions of more naïve investors.
Step 7) Encourage the entire investment culture to turn from quality to quantity, as if to say that one hundred pounds of pyrite is worth a great deal more than one pound of real gold. For example, Exhibit 3 of the Subcommittee’s investigation of WaMu contains a chart from a PowerPoint presentation given to its Board of Directors by the President of WaMu’s Home Loan Division on 18 April 2006. Contained on this chart is the rank order in terms of gain on sale for each type of loan that WaMu offered. The most notable type is the Subprime Loan with an ARM, at 150 basis points (a basis point equals one one-hundreth of one percent). This loan provided WaMu with eight times more profit than a fixed loan at only nineteen basis points.
In this new financial culture, volume reigned. Loan officers received commissions per loan and had their commissions increased if they met certain defined volume targets at their companies. In effect, they earned more from closing a high-risk loan than a low-risk loan. Loan processors garnered volume incentives along with entire loan-processing centers. Support of revenue-growth targets even entered into the evaluations of the risk managers who were supposed to serve as gatekeepers. The tail now was wagging the dog.
Step 8) If the risk of holding securities anchored in high-risk subprime mortgages appears too apparent, develop insurance policies through companies like American International Group (AIG) to guarantee these investments if their market value falls. In effect, this assurance of “no loss” further strengthens the market price for any security that may, in fact, be worthless. If a holder of one of the securities “sells short” (locks into a sale price well before a date of sale to hedge against a market decline), the next buyer inherits some assurance that s/he can gain protection from ill winds. If the first holder “goes long” (not locking in a price because they expect that the market value will rise) and the market falls, that holder can collect on his/her policy. What happens if every investor on the merry-go-round has insured holdings that plummet simultaneously? Not to worry. The taxpaying public can bail out the insurance company that is purportedly “too big to fail.”
Step 9) In order to prevent the bubble from bursting, insure that home values will continue to rise. Home prices recognize an average gain of about four percent per year over a course of fifty years. However, we see historically that values rise for a number of years and fall over time. Long-term housing value growth, which makes home ownership so appealing as a store of family wealth, is, nevertheless, an average of ups and downs between highs and lows. There is no short-term guarantee of increasing home values.
However, the heated market for mortgage-backed securities depends on the prospect of continuing gains in housing values at large. If the price keep rising, even the high-risk loans that became the fodder for securitization posed little problem. If a homeowner could not meet the obligation of a high-interest loan, then s/he assumed that his/her home either could be refinanced at a lower rate or sold at a profit in a rising market. Flip that house!
We recognize that home prices during the ten-year period preceding the bubble burst increased more rapidly than they had for decades. However, this above-normal rate of increase in home values appears to be due partly to the high-risk loans that allowed borrowers to buy more house than they could afford. Ergo, the rise in home values was artificially maintained above any firm foundation value in the market.
Step 10) Before the bubble bursts, encourage savvy investors to sell short and then leave the market. Those investors who anticipated the climax of the housing bubble wagered against existing mortgage-backed securities. Hence, they sold their holdings short to the rising tide of neophyte investors who wanted to take a ride on the Wheel of Fortune. In the case of many brokers, they sold their own holdings short while encouraging their clients to buy the same securities. Furthermore, through an instrument known as the Naked Credit Default Swap, some of these same brokers laid bets against mortgaged-backed securities that they did not even own.
“It Was the Best of Times, It Was the Worst of Times”
Opening Sentence of “A Tale of Two Cities” by Charles Dickens, (London: Chapman and Hall, 1859)
The bubble that was too big to burst finally did. Housing and mortgage-backed security prices stopped climbing and values tumbled.
For example, investment bank Bear Stearns operated two offshore hedge funds that specialized in mortgage-related securities. In July 2007, these funds collapsed suddenly.
Within weeks, credit-rating agencies downgraded hundreds of subprime mortgage-backed securities, leaving the market with a decaying cache of fresh fish.
Brokerage firms, banks, hedge funds, and others were caught holding bags full of rotting securities.
The economic assault had begun.
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Dr. John F. Sase of SASE Associates, Economic Consulting and Research, earned his MBA at the University of Detroit and his Ph.D. in Economics at Wayne State University. Sase can be reached at (248) 569-5228 and by e-mail at drjohn@saseassociates.com. Gerard J. Senick is a freelance writer, editor, and musician. He earned his degree in English at the University of Detroit and was a Supervisory Editor at Gale Research Company (now Cengage) for more than 20 years. 00Currently, he edits books for publication and gives seminars on writing. Mr. Senick can be reached at 313.342.4048 and by e-mail at gary@senick-editing.com.
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