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Bush Bail-out Plan: Treating the Symptoms and not Curing the Disease

On September 20, 2008, the Bush Administration submitted proposed legislation to address our current economic crisis.  The proposal gives the Treasury Secretary unprecedented authority and at least $700 billion to spend.  But why are we addressing symptoms: troubled mortgage-backed securities and not treating the underlying problem: subprime mortgages.

Unprecedented Authority

President Bush’s proposed legislation gives complete control over the purchasing of “troubled assets” to Treasury Secretary Henry Paulson.  One major problem with the proposal is that there is no oversight of the Treasury Secretary’s actions:

Sec. 8. Review.

Decision by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

So, Secretary Paulson can do what he wants with $700 billion.  This is an incredible amount of authority for one person especially given the extent of the supposed problem.  The lack of accountability is one reason why the mortgage crisis began and the Bush Administration wants to continue the lack of accountability with this proposal.

Where is the Transparency?

Why are the Bush Administration and Congress keeping this a secret?  If we are going to leverage the future of our children then we need to know the extent of the problem.  We have the technology put a presentation or Adobe Acrobat file online for all to see including independent economists.  We are being blackmailed into paying for a problem or crisis that we don’t know the full extent of and we are giving the former CEO of Goldman Sachs, Secretary Paulson, absolute authority to spend at least $700 billion.  We must demand to know the extent of the problem.

The Devil is in the Details

If you want to know the truth about a proposed law you have to read the language.  Check this out:

Sec. 6.  Maximum Amount of Authorized Purchases.

The Secretary’s authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time.

What does “at any one time” mean?  This does not sound like a hard set limit.  This can be interpreted to mean that Secretary Paulson could spend $700 billion immediately upon passage then a couple of months later if the $700 billion is paid down then spend some more.  If interpreted this way Paulson could spend more than $700 billion.

The definition of “mortgage-related assets” is what should make this proposal a non-starter.  This proposal gives Secretary Paulson the authority to purchase any “mortgage-related assets” from a financial institution.  Here is the definition of “mortgage-related assets”:

The term “mortgage-related assets” means residential and commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued before September 17, 2008.

Wait “commercial mortgages”!!!  So, the U.S. government can conceivably be bailing out real estate development loans or other commercial loan that Secretary Paulson wants to buy.  I thought this supposed mortgage crisis began with home mortgages or residential mortgages.  This definition could cover any financial scheme that was conjured up by an investment banking firm to further spread risk but may have little connection to actual home mortgages.  Could it be that credit default swaps are actually threatening the stability of the markets?  That is just speculation because, again, we don’t know the extent of the problem.

Focus on the Real Problem

The real problem started with home mortgage market particularly subprime mortgages.  Why not shore up this problem first?  According to the Center for Responsible Lending, in 2007, there was $1.3 trillion of subprime mortgages outstanding.  Most these mortgages are adjustable rate mortgages (ARM) that have reset or are scheduled to reset within the next year to much higher interest rates.

Restructure all outstanding subprime mortgages to fixed rate mortgages and eliminate any existing prepay penalty provisions from them.  The new fixed rate could be based on the cost of living in a certain area.  Don’t lower the principal of the loan just the interest rate.

A HUD-approved Housing Counselor can review the financial situation of a subprime borrower to determine if the borrower can afford the new mortgage loan.  If they cannot afford the mortgage loan then they must forfeit the house.  If approved, the borrower should be given the option of agreeing to the new terms or forfeit the house.  This would be a one-time offer and a subprime borrower has a limited time to decide what to do.

All forfeited houses can be purchased by the U.S. government at fair market value.  Any outstanding mortgage balance would be paid by the U.S. government to the mortgage lender/owner.  These forfeited homes then would be listed with a HUD-approved real estate brokers for resale.

This proposal would go to the heart of the problem and may end up costing less than $700 billion.  It would provide some structure and certainty to jittery financial markets.  It would preserve some home ownership for people.  This proposal would not be an overnight fix like the Bush Administration’s proposal, but so what.  Maybe, the credit markets need to slow down until the markets can clear out the mess created by financial institutions using mortgage-backed securities and complex derivative schemes.

Any legislative proposal regarding our current economic situation must define the problem, limit the scope of authority of the Treasury Secretary and specifically define what assets will be purchased.  If we are to bail out financial institutions then we must demand some form of restitution that could take the form of ownership or other claim to future earnings of the financial institution taking advantage of this corporate welfare.  President Bush’s current legislative proposal is a blank check that we cannot cash.

Please let your senator and congressperson know that we need accountability in any bail-out proposal.

 

 

Massive Meltdown - Part 3

This part 3 of 3.  Part 1 and Part 2 are here and here.

This mortgage crisis, turned financial crisis, turned absolute economic crisis, did not begin over night but has been brewing since at least the late 1990’s.  This crisis was instigated by a convergence of factors: low interest rates, increased subprime lending, popularity of mortgage-backed securities (MBS), corporate greed and deregulation.

Blinded by Greed

Did anyone in the mortgage industry really look at the quality of the mortgages or were they blinded by greed?

Here are just two examples of borrowers who received loans from BNC Mortgage, a former subsidiary of Lehman Brothers:

“One homeowner, Johnny Pitts, was a Muni bus driver who had bought an Oakland home for $429,950 in 2005.  His mortgage payment, which had started at $2,880, was about to reset to $3,730 a month – plus $750 more for taxes and insurance.  Home payments are supposed to be no more than 40 percent of income.  By that formula, the necessary income would have been $11,200 a month or $134,400 a year.  Was it reasonable to assume a bus driver was bringing home that kind of money?  In fact, Pitt’s take-home pay was just $4,000 a month.”

The other homeowners, Jeff and Vanessa Hahn of Fairfield, were on the hook for monthly payments of $5,000 – exactly the amount they earned together as a self-employed businessman and teacher.”

These examples are indicative of the fast and loose underwriting requirements that financial conglomerates had as they chased after bigger profits.  Just look at the size of the problem.  The government bailout is going to cost taxpayers at least $700 billion.

There will be people out there that say it is the borrowers’ fault because they should have known they could not afford the mortgage loans.  Yes, there is truth to that, but consider this.  You want the “American Dream” of owning a home and you hear advertisements saying interest rates are at an all-time low, no down payment necessary or low initial monthly payments.  So you go visit a mortgage broker/lender, who has instructions from his/her boss to make loans.  You sit down with someone who you think is an expert on mortgage financing and they tell you “don’t worry we will get you that house you wanted just pay us a $500 application fee to get the process started.”  In two weeks you get that loan approval.  You are in heaven because the “American Dream” is within your grasp.  You will have something of significant value that, who knows, maybe you can pass along to your kids – hell yes you are going to close on that house and mortgage.

What happened?

Greed.  Fraud.  Deception.  Add to that deregulation.  The Glass-Steagall Act of 1933 (actually they were two separate laws) prohibited a bank holding company from owning other financial companies and prohibited a bank from offering investment, commercial banking and insurance services.  The Act was a response to a collapse in portions of the U.S. commercial banking system.  Wow, sound familiar?

In 1999, the Gramm-Leach-Bliley Act was passed, as known as the Financial Services Modernization Act, in part named after Senator Phil Gramm.  Gramm-Leach-Bliley repealed the provisions of Glass-Steagall Act that prohibited banks from offering investment, banking and insurance services.  It essentially allowed commercial banks and investment banks to merge.  Today, we have large financial conglomerates such as Citigroup, Bank of America and J.P. Morgan Chase just to name a few.

But while tearing down the barriers to ownership for these financial conglomerates it also tore down the mechanisms that were preventing conflicts of interest between the profit objectives of banks, investment firms and insurance companies.  CEOs of financial conglomerates are going to push for what will make the most money or profit.  So, if the investment banking division is making a killing on MBS, he/she will tell the lending division to issue more loans even if it means lowering mortgage underwriting standards.

Advocates of Gramm-Leach-Bliley said that it was too inconvenient for consumers to go to separate places or entities for financial services.  So why not make it convenient for the consumer by having one place to get all your financial services.  Gramm-Leach-Bliley sacrificed the security and stability of our financial system for convenience and in the interest of increased profits for financial conglomerates.

We are left holding the proverbial bag.  But it is more than just the hundreds of billions (possibly trillions) of dollars of our money that is bailing out the gross negligence or greed of these institutions.  We are paying even more in terms of falling home values, and for many of us our home is our most valuable asset.  This crisis also threatens are savings and investments that we have worked hard to maintain.

But how is the federal government going to pay for this $700 billion?  By issuing more U.S. Treasury debt and burdening future generations of Americans.  So what, what is a few billion or trillion dollars here or there!  When are we going to learn that when corporations, and the people who run them, are given unfettered money making opportunities they will always take it to the extreme and beyond.  History is fulled with examples. 

 

Massive Meltdown - Part 2

Part 2 of 3.

This mortgage crisis, turned financial crisis, turned absolute economic crisis, did not begin over night but has been brewing since at least the late 1990’s.  This crisis was instigated by a convergence of factors: low interest rates, increased subprime lending, popularity of mortgage-backed securities (MBS), corporate greed and deregulation.

Part 1covers the interest rate environment during the 2000s and the size of the U.S. Mortgage Market.

What is driving this runaway train?

Where were these mortgage lenders getting all of this money to make billions and trillions of dollars in loans?  Something had to be driving this mortgage frenzy besides low interest rates.  It was the bond market particularly the market for mortgage-backed securities (MBS).

Mortgage-backed securities (MBS) are typically bonds – fixed income securities.  They are sold on the open market meaning investors like banks, pension funds, mutual funds, corporations or individuals (usually through a brokerage accounts) can purchase MBS.  The interest and principal on these MBS are paid by the pools of mortgages that Fannie Mae and Freddie Mac have bought from mortgage lenders.  As an owner of MBS, investors have a claim on a pool of mortgages that Fannie Mae or Freddie Mac have in their possession.

Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) are government sponsored enterprises created by Congress in 1938 and 1970, respectively.  Fannie Mae and Freddie Mac provided banks and other mortgage lenders with new money to make more loans by buying mortgages and pooling/packaging these mortgages for resale via MBS, or by owning the mortgage loans outright.  Although they were created by Congress, Fannie Mae and Freddie Mac received no direct federal government aid.  In fact, they were actively traded companies on the New York Stock Exchange.

How did this deal work?  Lenders would make the mortgage loans and then package or pool these loans and sell them particularly to Fannie Mae and Freddie Mac.  The lenders then would take the money they got for the loans from Fannie or Freddie and would make new loans with a portion of the money.  What an incredible money making cycle!!!

Lenders would get a piece of the action when they made a mortgage loan and then a get a little more when Fannie Mae and Freddie Mac bought the loans.  And it was practically risk-free to the lender because they no longer owned the loan – it was now Fannie Mae’s and Freddie Mac’s problem.  I saw mortgage brokers everywhere.  I remember I was at a real estate closing and I overheard a mortgage broker talking to his “investor” about the volume of their business.  The money quote from the mortgage broker was “we are going to have a nice Christmas.”

Fannie and Freddie would take these pools of mortgage loans and do what is called “securitize” them meaning they would issue MBSs that were backed or paid for by the pools of mortgages they bought from mortgage lenders.  Fannie Mae and Freddie Mac would then sell the MBS on the open market to investors – mutual funds, pensions, banks and corporations.  The MBS market was huge mostly driven by Fannie Mae and Freddie Mac.  According the Bond Market Association, at the end of the first quarter of 2006 the market value of the outstanding MBS was $6.1 trillion.  This was far greater than the value of outstanding U.S. Treasury Securities – $4.19 trillion.

These MBS are high-yielding, highly liquid investments – very attractive to investors.  Fannie Mae and Freddie Mac were doing their job of providing the home mortgage market with capital and liquidity or so it seemed.  This was a very profitable business for Fannie and Freddie as well it should because their purpose was to help the home mortgage market and in return help us.  These MBS were providing a good return for their shareholders.

Meanwhile, investment banking firms such as Lehman Brothers and Bear Stearns were looking at this MBS market and thinking they needed some of this action.  And big money center institutions like Bank of America and Citigroup were thinking wait we own banks that make the mortgages and we own investment banking firms to issue the MBSs.  Holy jackpot!!!

The independent investment banking firms such as Lehman Brothers and Bear Stearns, who were not part of a larger banking institution, had to figure out something.  Do they compete with Fannie Mae and Freddie Mac for the pools of mortgage loans which would bid up the price of these pools from mortgage lenders (bad for the profit margin) or do they open a mortgage company that would generate mortgages so that they can vertically integrate their business like a Bank of America or Citigroup and capture more fees and margins internally.  Guess what… Lehman Brothers owned a mortgage company called BNC Mortgage and guess what kind of mortgages they made – subprime mortgages.

Common ownership of lending arms and investment arms by financial conglomerates created a dangerous vertical integration of a major portion of the U.S. mortgage industry.  Major financial conglomerates owned the banks/mortgage companies that make the mortgage loans and they owned the investment banking firms that were issuing the MBS that were backed by or “securitized” with those mortgage loans.  But, it does not end there because they began spreading any risk in these MBS to investors such as pension funds, other banks, corporations and individuals.

The Race to the Bottom

Think about this.  You are the Chairman/CEO of a financial institution that owns a bank or mortgage company, and an investment banking firm.  You want to get a big multi-million dollar bonus at the end of the year and you don’t want to hear someone yapping on CNBC or on the phone about how the institutions stock price is in the tank.  You know that making loans and issuing MBS are both very lucrative businesses for the institution.  So, what does it matter if the head of the banking division (who also wants a big bonus) opens up the mortgage loan spigot by loosing mortgage underwriting requirements.  No down payment - no problem.  Bad credit – no problem.

The investment bank head is saying I need more mortgages because I can’t keep up with the demand for these MBS.  As chairman/CEO, you know that any risk from the underlying mortgages is now being spread out in the MBS market.  What are you going to do?  So, you, as chairman/CEO, set a strategy of exploiting the opportunities in the mortgage industry by loosing mortgage credit and issuing more MBS.  The only obstacle to this strategy is the competition from the market but you are confident that you can beat your competition so you go for it.

Prior to 2007, Fannie Mae and Freddie Mac chairmen/CEOs are sitting on all-time high stock prices hovering at $70 per share and multi-million dollar compensation packages.  Things are good.  But they have to keep up with the other financial institutions in the MBS market and provide a high return to their shareholders.  So they too have to buy more mortgages but even if it includes more subprime mortgages.  But just in case issuing MBS did not provide a high enough return,  Fannie and Freddie bought and held the same risky MBS that they and other financial institutions were issuing/selling.  As of June 2007, Fannie Mae and Freddie Mac owned $168 Billion of MBS backed by subprime mortgages.

Fannie and Freddie were not alone.  Lehman Brothers, Bear Stearns and many other investment banking firms bought/invested in these risky securities.  The investment strategy was that they were going to capture the “bond yield spread” between the MBS they issued and sold in the bond market with those they bought or invested in on the bond market.  The bond yield spread was used as a way to reduce risk - a hedge.  This strategy worked if the yield spread was close and prices on the MBS would trend higher.  But reality began to destroy this investment strategy.

Meanwhile, what is happening with the subprime borrowers?  Those ARMs (adjustable rate mortgages) that provided that very attractive initial low monthly payment were beginning to reset at much high interest rates.  In many cases, because of the prepayment penalty, the subprime borrower could not afford to refinance.  These borrowers, faced with much higher mortgage loan payments, begin to default on their loans.

The result was cataclysmic.  It was like a house of cards.  These increase loan defaults immediately impacted the MBS market.  Investors became jittery about the possibility that Fannie and Freddie may default on MBS they issued.  Investors start selling or avoiding MBS resulting in significant decreases in the price of MBS.  Bond yield spreads used by Fannie, Freddie and the financial conglomerates begin to unravel resulting in huge (billions of dollars) investment losses to them.  The MBS the Fannie, Freddie and the financial conglomerates usually issue were significantly devalued which practically crippled them from raising more capital.  So, the stage is set for the government bail out of Bear Stearns, Fannie, Freddie and a major portion of our financial system.

Remember AIG, this “insurance company” not only invested in these MBS but it also invested in complex financial instruments (credit rate swaps) related to its insurance of MBS and if that was not enough AIG owned a subprime mortgage company.  Where were the regulators?

We are paying the price for Fannie’s, Freddie’s and the financial conglomerates’ incredibly poor strategic and investment decisions.  The price tag for this failure: $700 billion and growing; so much for “free markets.”

Massive Meltdown: A primer on the Economic Crisis of 2008 - Part 1

This is Part 1 of 3.

Author note: This story will be divided into three parts in the interest of being thorough and because of the importance of the issue.

How did we get to where we are at today? Financial institutions are failing. Lehman Brothers (159 years old) bankrupt, American Insurance Group (AIG) bailed out, Fannie Mae and Freddie Mac bailed out and now our government is going to bail out the entire mortgage industry.

That will cost us, taxpayers, at least $700 billion. We need to understand how we got into this mess because it appears we never learn from history.

This mortgage crisis, turned financial crisis, turned absolute economic crisis, did not begin over night but has been brewing since at least the late 1990’s. This crisis was instigated by a convergence of factors: low interest rates, increased subprime lending, popularity of mortgage-backed securities (MBS), corporate greed and deregulation.

Cheap Money, Low Rates, Gobs of Money to Lend

In 2000, the Federal Reserve, the interest rate leader, began cutting the Fed (Federal) Funds Rate:

May 2000	6.50%
May 2001	4.00%
Dec 2001	1.75%
Jun 2003	1.00%
Sept 2008	2.00%

This meant the cost of borrowing money became cheap. The Fed believed that economic activity was slow so it cut the Fed Funds Rate in the interest of increasing business activity which would increase economic growth. At least that was the theory behind these rate cuts.

So what was happening in the mortgage market at this time? Mortgage rates are determined by several factors including demand for mortgages and longer-term interest rates such as 10 year U.S. Treasury Note. But where were interest rates (average) for a 30 year fixed mortgage during this time period:

May 2000	8.52%
May 2001	7.15%
Dec 2001	7.07%
Jun 2003	5.23%
Sept 2008	6.48%

Average mortgage rates were definitely lower than their the peak of 8.52%. These mortgage rates made for a very attractive lending environment. Just look at the numbers:

Amount of Home Mortgages Outstanding (Billions of Dollars)

2002	6,036.2
2003	6,887.1
2004	7,845.4
2005	8,875.8
2006	9,872.9
2007	10,542.7

Source: Federal Reserve, Z1 Release, September 18, 2008

Mortgage loan activity increased ever year between 2002-2005. At the end of 2007, U.S. households were carrying $10.5 trillion of mortgage debt. The home mortgage market was huge. But the increase in mortgage activity certainly was not the sole reason for the mortgage crisis. The quality of the mortgage loans, particularly subprime mortgages, was a big problem. Subprime mortgage market exploded between 2003-2007.

Increase in Subprime Mortgages – too much of a good thing?

Subprime mortgages are “high-cost to borrower and high-risk to lender” loans intended for people with weak or bad credit. Subprime lending does provide much needed capital to an underserved market. It gives people with less than stellar credit an opportunity to create wealth. But at what cost to the borrower and the community at large? Was the number of subprime mortgages too much of a good thing?

Subprime mortgages cost more than a prime mortgage in terms of fees and higher interest to the borrower. For example, a prime fixed-rate mortgage rate maybe 6.0% but the mortgage rate on a subprime loan could be anywhere between 8-11%, depending on the credit score and the amount of down payment by a subprime borrower. Then there are fees – origination, application and others. The fee structure for a subprime loan is higher because more loans applications are rejected and higher marketing costs which means higher overhead for subprime lender. These fees and interest rates are designed to compensate the subprime lender for the risk it is taking making these loans.

These loans usually come with a prepayment penalty clause, something that is extremely rare in the prime mortgage market. That is correct – a subprime borrower may have to pay a penalty to pay-off the mortgage! In most cases it is thousands of dollars that must be payed by the borrower if they pay off the mortgage within a minimum of 2 years of closing. I personally have seen prepayment penalties as high as 3% of outstanding loan balance or 6 months of interest.

Why the prepayment penalty? In theory, it compensates the lender for “prepayment” risk but the penalties also make these subprime mortgages more valuable when the lender tries to sell these types of loans to Fannie Mae, Freddie Mac or an investment banking firm. Bottom line: lender can get more for a subprime mortgage with a prepayment penalty when it sells the mortgage loan.

A common loan term structure in the subprime mortgage loan market is 2/28 Adjustable Rate Mortgage (2 year fixed period/28 year loan ARM). This means that the mortgage rate is fixed for 2 years but after 2 years it jumps or resets to a much higher interest rate – in most cases the reset is equal to an index (ex. prime rate) plus a fixed margin. For example, a subprime borrower has an initial rate of 8% mortgage but at the of 2 years the mortgage resets and if the index is 3% (prime rate) plus a margin of 7% then the mortgage rate will reset to 10%.

The theory behind 2/28 ARM is that the borrower will work on improving their credit during the two years then refinance to a lower rate mortgage. The problem is that there is typically a prepayment penalty to pay-off a loan before 2 years (in some cases more). So, a subprime borrower is stuck in this loan, which now has a much higher interest rate.

The subprime mortgage market was a very lucrative industry in early 2000s. There were independent mortgage companies such as Ameriquest Mortgage, Countrywide and New Century Mortgage Co. Even the big money center banks like Wells Fargo and Bank of America, through subsidiary companies, got a piece of the action.

According to the Center for Responsible Lending (CRL), in 2003 the amount of subprime loans outstanding was $322 billion and in 2007 the amount outstanding was $1.3 trillion. Subprime mortgage loans increased 292% between 2003 and 2007. In 2007, 7.2 million families held a subprime mortgage. It gets worse: CRL projects that $164 billion of home equity will be lost through foreclosure by families holding subprime mortgages.

This is too much risky loan activity. By 2007, about ten percent (10%) of outstanding home mortgages were subprime mortgages. But did anyone care – mortgage lenders/brokers were making money and banks were making money. Besides, there were gobs of money to lend.

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