Last week, the Chairman of the Federal Reserve, Ben Bernanke, told Congress that he didn’t know what to do about the economy and the repeated need for bailouts. This week, the Oracle of Omaha Warren Buffett, Chairman of Berkshire-Hathaway told the press that he couldn’t understand the financial statements of the banks getting the bailout money.
This made it a daunting challenge the other day, when the Program Director for the Bellevue (Nebraska) Kiwanis Club asked me to talk to his group about the current state of the economy. Despite the many often outrageous examples of excessive greed and even criminality, the current debacle began with good intentions: provide opportunities for homeownership to a segment of the population that was historically left out.
New credit rating systems had to be developed to take into consideration the fact that some immigrant groups prefer to live in extended families (multiple generations in one household). The individual income of any one may not qualify for a loan, but they would all be paying the mortgage. Yet, their family patterns meant assets are only held by the male head of household. That’s just one example, and there are many more. It’s just that banks and others came to realize that the existing systems were excluding people who would actually be very good borrowers. The original “subprime” borrowers were like the original “junk bond” companies – they didn’t fit the mold of a model credit customer. But among them were MCI and Turner Broadcasting – plus Enron and Worldcom, of course.
Like junk bonds, the new mortgage product came to be abused by borrowers and lenders alike. This was made worse by developments that blurred the line between banks and brokers. Both parties participated in actions that allowed banks to have their in-house brokers sell off their mortgage loans to Wall Street in the form of bonds. This is called “originate and distribute”. The same bank wrote the mortgages, packaged the loans for sale and distributed the bonds to their clients – collecting fees at every stage.
And here’s where greed entered the picture. The demand for these bonds completely outstripped the supply: senior management put pressure on the troops to write more mortgages and sell more bonds. The fees were pouring in from everywhere. The demand was so great that an average of 40% of the trades failed for lack of delivery – broker-dealers were selling more bonds than were issued. Each bond trade, whether or not there was a failure to deliver, resulted in a commission for the buying and selling broker-dealers. They didn’t have to tell the buyers that there was no delivery – the broker-dealers figured they could fix it later. This was the initial breakdown in regulatory oversight.
The next one came when no one was watching over the credit rating agencies. According to a story on PBS (originally aired November 21, 2008), managers at Standard & Poor’s credit rating agency were pressured to give the bonds triple-A ratings in the pursuit of ever higher fees. (We’ve yet to learn all the details of the potential collusion between banks, brokers, rating agencies, etc., but more news is coming out all the time – stay tuned!)
Along the way, it became clear that these investments in mortgage bonds were, in fact, risky – despite their triple-A credit ratings. That’s where the credit default swaps came in – credit default swaps (or CDS) are simply contracts akin to insurance policies. The bond holder pays a small premium up-front and they get all their money back if the bond goes into default which could happen, for example, if the homeowner owing the mortgage in the mortgage bond ends up in foreclosure. This was another idea with good intentions – it made the bonds more popular and sent more money back to the bank for more mortgages.
The way the theory on structured securities was developed, if a bank can sell the mortgages they can use that cash to write more mortgages and so support local communities that need to expand housing opportunities. It should also disperse the risk, spread it around, so that some economic problem in one town, like a factory closing, won’t cause the local bank to go out of business. Losses on local mortgages would be spread out geographically, spread out over a large number of investors and over different types of investors (individuals, companies, pension plans, etc.) so that no one of them should suffer all the damage.
Greed enters the picture again: instead of the CDS derivatives being sold only to the people who owned the bonds and only in a quantity equal to the value of the bonds that were issued, an unlimited number of swaps were sold. This is as if you have a $1 million home and someone sold you $20 million worth of insurance. The temptation to burn down the house was just too much. What you see now is arson. They are burning down “the house” to collect on the insurance. Except if it were your typical insurance it would be regulated and you would have to have “an insurable interest” in hand to buy the policy at all. This insures that there would be no more derivatives issued than there are assets. No, these CDS derivative contracts are completely unregulated and unmonitored.
Sadly there were no video surveillance cameras in place when Wall Street was spreading around the gasoline and striking the match. Yet now we are stuck watching the house – and the economy – burn down.
Susanne Trimbath, Ph.D. is CEO and Chief Economist of STP Advisory Services. Her training in finance and economics began with editing briefing documents for the Economic Research Department of the Federal Reserve Bank of San Francisco. She worked in operations at depository trust and clearing corporations in San Francisco and New York, including Depository Trust Company, a subsidiary of DTCC; formerly, she was a Senior Research Economist studying capital markets at the Milken Institute. Her PhD in economics is from New York University. In addition to teaching economics and finance at New York University and University of Southern California (Marshall School of Business), Trimbath is co-author of Beyond Junk Bonds: Expanding High Yield Markets.