The Disease That Was Subprime Lending

Those who think that the subprime mess was an unfortunate accident that could not be anticipated by management should read a BusinessWeek story called Sex, Lies, and Subprime Mortgages. Fraud and trading of sexual favors for mortagages that could be bundled into hot securities were supposedly common, and whistle blowers were shut down by managers who didn't want the good times to end. What went on was literally criminal, and I suspect that the major Wall Street institutions simply turned blind eyes to everything in their quest of deals that could yield profits and a quick exit before the players got caught. Unfortunately, the collective moral depravity set off a chain reaction that we will be facing for years. It does make me wonder what similar may have gone on in credit default swaps, credit card-based CDOs, and other such debacles.

Renters: Another Impact of the Mortgage and Credit Crisis

When people cannot pay for the buildings they purchased, those properties go into foreclosure. And when the people who bought purchased multi-family dwellings, perhaps thinking that renters would pay for the mortgage, there's the chance that multiple families will hit the streets in the foreclosure process. It's a hidden aspect of the mortgage crisis. According to Crain's New York Business, a new survey suggests that 38,000 tenants live in 15,000 buildings that went into foreclosure last year:

Foreclosures could leave tens of thousands of New Yorkers who live in rental apartments without places to live, according to an analysis released Monday by New York University’s Furman Center for Real Estate and Urban Policy.

Nearly 60% of the 15,000 foreclosure filings in New York City last year involved two- to four-family or multi–family buildings. That means renters, and not just owners, could be sent scrambling.

So where are these people supposed to go? And is anyone tallying their costs as part of the mortgage crisis?

Did the Feds Topple Bear?

New Jersey Institute of Technology management professor Michael Ehrlich has an interesting premise. A former government arbitrage trader himself, his research and background suggest to him that by announcing that it would make $200 billion available to finance securities from investment banks, the Fed may have unintentionally set off the panic that claimed Bear Stearns.
"I think it's a bad thing for Bear Stearns shareholders, but a brilliant thing for public policy," Ehrlich says. We've established a precedent that they're prepared to bail out firms to protect the little guys ... but that the people responsible bear the costs."

As he says, that means management and the shareholders. I think some of those shareholders often may be little guys, but, realistically, this is capitalism and they continued were holding stock in a company making ever riskier trades because they liked the returns.

The minute the Federal Reserve made the announcement, everyone in the markets started asking whether the Fed knew something that they didn't, which may well have triggered speculation about Bear Stearns - smallest of the investment banks - that turned into "a classic run on the bank," according to Ehrlich.

I keep asking myself the question of whether the Fed's new willingness to lend to investment banks might be handing more money to the very organizations that have proven themselves so tremendously reckless. Ehrlich thinks I'm looking at it the wrong way, and that the effect is to keep the financial system propped up while the shareholders take the brunt of the heat.

But I still feel unconvinced, because I think businesspeople are likely to take this as a tacit guarantee that no matter how stupidly they act, someone will pull their chestnuts out of the fire. All they need to do is keep diversified enough that their estates don't get clobbered like those of the Bear employees.

In any case, Ehrlich also thinks that this is by no view charity on the part of JP Morgan. As he deemed the Fed's move for public policy, so he called the acquisition a "brilliant" move that will probably give the new owner a profit of several billion dollars. Guess I don't see that as something to dissuade behavior in the future - because all the high-powered type A's will assume that they will be the ones coming out on top. We've seen the same behavior in virtually every man-made financial calamity in history, and there's no reason to think that people will act much differently. The only question is how much time it will take them to get back to the usual business.

Paulson Adresses Everything But Real Problem

I was driving about on errands with my daughter and was listening to NPR when I heard US Secretary of the Treasury Henry Paulson speak at the National Press Club talk about how the Bush administration was going to fix the credit crisis:

1. Wag a finger at the regulators for not making mortgage lenders explain in plain English to borrowers just what the hell they were in for.


2. Plead with lenders to keep lending, because, after all, if the public isn't borrowing, it's not spending.


3. Actually toughen licensing standards for all those mortgage lenders who can't make loans anyway because no one will front the money because of the mess the mortgage market is in.


4. Have regulators "catch up with innovation and help restore investor confidence but not go so far as to create new problems, make our markets less efficient or cut off credit to those who need it."


5. Cluck at sloppy lending practices.


6. And, of course, let industry self-regulate.

He managed to miss the major issue: when you've got people who are incredibly greedy and who have forgotten their duties to business, the markets, and the public in general, then they will continue to create complex, crackpot schemes to extract cash from the pockets of others and put it into their own. If the financial industries could regulate themselves, don't you think they might have by now? They don't because they don't want to be limited in what they do. The people in charge of all these stupid Ponzi schemes want to continue their quest for unending and unrestrained profits. That's like saying you want so much water from a well that you pump it dry. Now you're left with no water, and no prospect of getting any.

This is a case where self regulation will do nothing. The longer the federal government waits, the more cash it will have to create out of thin air to grease the market's wheels, and the more value of the dollar it will burn off, probably never to return, at least in our lifetimes.

Legal Snag in Credit Mess

Gretchen Morgenson has been doing a good job for the New York Times of following some of the more interesting threads in the credit meltdown. She has a story about a legal snag on the mortgage front - a federal judge in Ohio has dismissed 14 foreclosure cases brought by mortgage investors because they didn't prove that they had title to the properties they wanted to seize:

But as foreclosures have surged, the complex structure and disparate ownership of mortgage securities have made it harder for borrowers to work out troubled loans, in part because they cannot identify who holds the mortgage notes, consumer advocates say.

Now, the Ohio ruling indicates that the intricacies of the mortgage pools are starting to create problems for lenders as well. Lawyers for troubled homeowners are expected to seize upon the district judge’s opinion as a way to impede foreclosures across the country or force investors to settle with homeowners. And it may encourage judges in other courts to demand more documentation of ownership from lenders trying to foreclose.

I hadn't realized that the structures put additional squeeze on the borrowers, but if it works against one, then it's going to work against the other. The cases were brought by Deutsche Bank National Trust Company - amusingly enough, Deutsche Bank is one of the firms that is being least affected by the meltdown. When asked for proof of assignment of the mortgages, the bank's lawyers could only dig up letters of intent to transfer, and not the actual documents that would have shown ownership. As the judge wrote (and paper reported):

The institutions seem to adopt the attitude that since they have been doing this for so long, unchallenged, this practice equates with legal compliance. Finally put to the test, their weak legal arguments compel the court to stop them at the gate.

One source said he had heard of cases where a loan was in more than one pool, and there is apparently no repository showing who has what. Here's another snippet from the story:

And a recent study of 1,733 foreclosures by Katherine M. Porter, an associate professor of law at the University of Iowa, found that 40 percent of the creditors foreclosing on borrowers did not show proof of ownership.

No proof of ownership would mean no standing to sue - and although I'm not a lawyer, I think this problem is going to run very deep. It's not just about foreclosures. You have huge pools of securities that are based on owning these loans, only if you can't prove that you own the loans, are you now in the middle of securities fraud?

O'Neal, Merrill Lynch, and Boards

Via a PR person, I heard from Ron Garonzik, vice president of leadership talent at Hay Group, a New York-based consultancy. He thinks that Merrill Lynch's board is making a mistake in naming a board member as even an interim CEO.

The fact that its Board has appointed a board member -- a non-executive chair -- is indication of the absolute breakdown of its accountability of ensuring business continuity for Merrill’s most critical management positions. The success rates of outside CEO hires are grim: it is well documented that the chances of getting the boot of a forced resignation are much higher for external CEO hires as compared to insider hires (by 20 percentile point or more for North American companies).

That certainly squares with what I've heard over the years. Plus, if a company develops candidates internally, it isn't at the economic mercy of someone from the outside who already probably has a good deal and whose personal fiscal future now has to be guaranteed under what are now more questionable circumstances.

I did take some exception to the idea of a breakdown of the board's accountability, but Mr. Garonzik did have a good explanation:

The breakdown in accountability isn’t about the stopgap measure of appointing an interim CEO – but rather that fact that no credible successor is waiting in the wings to take over from O’Neal. As if things weren’t bad enough with Merrill’s name being dragged through the mud with investors, and that they have to deal with the negative publicity concerning O’Neal’s departure package. On top of all that, they have to deal with the uncertainty of not having a pair of steady hands at the helm of a venerable “Wall Street” firm. That alone is evidence of the board’s failure to meet it’s accountability of ensuring business continuity.

Now here's where the board really fell down. When O'Neal was coming up through the ranks, so were a number of other people. But the CEO got rid of much of Merrill's old guard - and potential successors, or challengers. The board allowed him to do this, which really was foolish. The evidence is that the board evidently had to consider a short-gap measure and someone from the outside to follow. A company with a well-developed succession plan always has someone who could reasonably well take over.

Unfortunately, this isn't going to be an issue just for Merrill Lynch. Investors are calling for the head of Citigroup's Charles Prince. Does that company have talent ready to go? And if New Jersey Institute of Technology finance professor Michael Ehrlich is right, structured investment vehicles - the class including the securitization of mortgages - could still face another $30 billion to $50 billion in losses. According to this from a press release:

The SIV rescue attempt, led by JP Morgan, Citibank, and Bank of America with US Treasury Dept encouragement, will not stop the losses, Ehrlich said. The SIV bailout fund known as the Master-Liquidity Enhanced Conduit (M-LEC) will, at best, slow down losses because there is no Federal bailout money in the plan.

"The fundamental market mispricing of the real estate and also the credit risk markets will be corrected," said Ehrlich. “In the best case, the M-LEC might forestall a panic leading to an over-correction in pricing. Unfortunately, there is likely to be the unintended consequence that the M-LEC will discourage new capital from flowing into this market.”

That leaves the question of the red ink or the blood on the water will spill faster.

Mortgage Superfund Worrying Financial Experts

Although the Treasury may be involved with the concept of bringing together Citigroup, Bank of America, and JPMorgan to create a $75 billion fund to help prop up a sagging mortgage market, not all experts think it's a good idea. Alan Greenspan questioned whether it was wise to intervene in the market, as reported by CNNMoney.com and others. Today, the Financial Times reports that during a trip to South Korea, Warren Buffett has added his own voice of wariness:

“One of the lessons that investors seem to have to learn over and over again, and will again in the future, is that not only can you not turn a toad into a prince by kissing it, but you can not turn a toad into a prince by repackaging it,” Mr Buffett said during a one-day visit to South Korea.

“But very imaginative people in the securities market try to do that. If you have bad mortgages they do not come better by repackaging them. To some extent the chickens are coming home to roost for the mortgage originators and securitisers,” he said.

Both of them have expressed concern that the market should be the force stabilizing the situation, and not governments and banks. I'm not the most laissez faire guy in the world, but in this case I'd tend to agree. The people who set up these investments and who then promoted the hell out of them tried to build with sub-standard materials. You don't fix a wall by painting it. You fix it by finding the weak spots, reinforcing the structure where necessary and replacing the fallen plaster. (I use this analogy because it literally hits close to home, as I'm in the process of fixing a wall.)

To use the money to boost prices unrealistically might make some well-off people happy that they don't take a bath, but to be fair, many of the people who bought into these loans are bearing a heavy burden at the moment. Why should they be the only ones paying the price?

I can hear some people thinking it now: They should have known what they were getting into and seen that they shouldn't have taken more loan than they could afford. But we could say the same about the investment crowd. If anyone should have known what they were getting into, it should have been these people. That's what they do for a living. Artificially reduce the pain, and not only do you run the risk of only temporarily propping up this financial Rube Goldberg machine with a more painful crash to come, but no one learns anything from the experience. They become the Peter Pan crowd that never grows up and never learns that actions have their consequences. If they lose money, well, then they lose. Hopefully they will be more prudent about future investments, and they are also unlikely to face living on the street as a strong possibility, as are many who the very same investors expect to manage with increased mortgage payments and no greater financial resources.

Blooming Housing Crisis

All the powers that be in economic circles keep saying that the housing crisis hasn't spilled over yet into the rest of the economy. But this is sounding like so much whistling in the dark - or, perhaps, trying to keep those ever irrational markets from wigging out - and it's not clear that they can keep it up with a straight face. First, the Wall Street Journal Online reports:

In a model of central-banker understatement, Mr. Bernanke noted to the Economic Club of New York that "the past several months have been an eventful period for the U.S. economy." And he recounted the mortgage meltdown, market panic and increase in Fed anxiety about the economy that prompted a reversal of the Fed's risk balance toward growth worries and the resulting half-percentage-point reduction in the cost of borrowed money last month. While members of the Federal Open Market Committee agreed Sept. 18 that "significant spillovers [from housing-market trouble] to household and business spending were not yet evident," the downside risks to both had clearly increased, exacerbated by "somewhat downbeat consumer sentiment, and slower growth in private-sector employment."

The WSJO continues, calling feedback that the Fed is getting from local bankers and executives "a darker description" than that collected and published before the Fed came out with its Beige Book report, a collection of "anecdotal information on current economic conditions" each branch of the Fed gathers from "key business contacts, economists, market experts, and other sources." The Treasury department is trying to build a coalition that will help stabilize the mortgage markets, August housing starts in Japan were down 43 percent from the same period in 2006, and, according to NPR, the US foreclosure rate is the highest it's been since the Great Depression. At this rate, how can conditions not spill into the rest of the economy. It sounds as thought it already has, only no one has wanted to be the first to say it.

Banks Start Fund for Credit Market

Working with the Treasury department, Citigroup, Bank of America, and JPMorgan Chase are creating a fund that will buy between $75 billion and $100 billion in structured investment vehicles (SIVs) - the mortgage-backed securities that have seen such trouble recently. The New York Times has a story that has yet another piece of the puzzle, which can be hard to grasp if you come at this from the outside, like I do:

The effort is intended to help SIVs that need to sell securities do so in an orderly manner. Bank and government officials are concerned that if these vehicles are forced to dump billions of dollars worth of debt in the coming weeks, it could cause a repeat of the crisis that rattled markets in August and sent the cost of mortgages and other loans soaring.

In other words, these SIVs, like many other forms of financing, come with strings. The people running them have to ensure certain conditions or face serious consequences, like being declared in default (or whatever the equivalent for an SIV would be):

[Christian Stracke of the research firm CreditSights]said that by serving as another buyer of the highest-rated securities, the banks are hoping to ease the immediate strain on SIVs, which could be forced to sell billions of dollars worth of assets in a fire sale if they are not able to raise new financing and when their capital falls below certain thresholds. The effort, however, will not resolve the longer-term problem many SIVs face with more risky mortgage bonds, he said.

The SIVs have financial covenants, and they cannot allow their free capital to fall too much. So they need to sell more short-term debt to keep investing in the long-term debt to get the cash flow to pay off the short-term debt and keep afloat. It sounds, to me, like a legalized version of a Ponzi scheme, but then I'm not a high finance person.

Supposedly the fund - called a conduit - will invest only in top rated securities and won't help the sub-prime area that has most of the fundamental trouble. But then, one of the main problems has been that the rating agencies apparently were favorable in their ratings for the sub-prime. Why should anyone believe that a AAA rating actually means anything, either?

“For me, this is more of a P.R. blitz,” he said. The banks are “saying, it’s not just that we are doing this on an ad hoc, individual basis. Rather, we have a plan and consortium in cooperation with Treasury, which gives it a veneer of respectability.”

But the institutions themselves have lost tremendous credibility because of culpability. Maybe people will forget, or maybe the new investments are actually sound. The question is who will bet on that?

More Debt Madness Upcoming?

I'm on a number of specialty email lists, including one from a major international risk management firm. It ran an opinion piece from a reader who noted something that I hadn't realized: companies have created the same types of security derivatives based on debt for the credit card market as they have for mortgages. This should shake everyone's shoes.

People have been living on credit, at least in the US, as many have noted. Fueling much of their buying has been low mortgage rates. People refinanced, pulled out cash, and made purchases, thinking that higher housing prices would cover their rears. Now that it's ending, and many mortgages are suddenly rising in price, they will start turning to credit cards.

According to this opinion piece, the US has a total of $904 billion in revolving credit debt - mostly credit cards. The UK has $100 billion on plastic. Bank of England data says that British banks have written off $18 billion in bad debt over the last 12 months. Moody's suggests that American credit card companies have seen bad debt jumping by almost a third in one year.

Credit cards are the last refuge of those not making more money who are trying to manage higher costs of living, and that's piling a lot of weight on what appears to be a flimsy structure. If you thought the sub-prime mortgage situation was a fiasco, what do you call what will happen with credit cards? Unmitigated disaster? Or depression?

Good Credit? Bad Credit? How About Smoke and Mirrors

The news of Countrywide Financial seeing more borrowers with good credit falling behind on mortgage payments sent the markets into a scurry. But, really, what have they been expecting?
The New York Times in the first graph of their story noted "that the housing market might not begin recovering until 2009 because of a decline in house prices that goes beyond anything experienced in decades." Well, folks, we had the most insane run-up of housing prices for, what, a decade? When will people start looking at history and nature? Nothing lasts forever: not reputations, not nations, and certainly not economies.

Housing prices went up giving people all sorts of wealth - on paper. So what did the mortgage lenders and banks rush to do? Get them to take out equity. As I was reading in the Financial Times (sorry, no link), what really caused the problems for Countrywide were home equity loans where deliquency rates had more than doubled over the period of a year. What compounded that problem was a practice that many lenders have entered: a form of credit washing. Lenders took combinations of loans, mixing different credit risks, and got large lump sums by selling the loans off to legally insulated subsidiaries and then selling high-yielding securities. They essentially washed off any credit taint by saying that even if some loans defaulted, the rising housing prices would ensure the ability to maintain cash flow. In other words, they were juggling numbers and betting that a rising tide would float their rears out of trouble. But it all depended on those prices going up. That's over:

a conference call with analysts that lasted three hours, Countrywide’s chairman and chief executive, Angelo R. Mozilo, said home prices were falling "almost like never before, with the exception of the Great Depression."

This shouldn't have been hard to see. Hell, I saw this coming and so did various people I know, because none of us think that the good times last forever. Prices were at a point that people could no longer afford to get more and more - there's only so much of your income you can devote to something like housing. So people stay put, buying drops, and of course the prices drop. Then people can't move, because they're in hock up to their eyelashes and can't get the price to clear them of debt, meaning that selling the family manse would leave them cowering in the financial basement, so to speak.

Now the experts are saying that it will take until 2009 for home sales to recover. I don't believe them. This is a precarious log jam. More payments will be late, panicky lenders will recall loans (because that's what they do), more houses will be on the market, driving prices lower, with even more people stuck. Every time prices drop, more people find themselves in this trap as the barrier to being dangerously financially leveraged gets lower and lower.

So, we heard in 2006 that it would get better in 2007. Then we heard 2008 earlier this year. Now it's 2009. By the time the finance types admit that there's a significant problem, it will be the next great depression. How depressing.