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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.”