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Financial Reform: It's Not Rocket Science
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The majority of the financial ‘experts' in the world did not see the credit crisis coming, including the Federal Reserve, SEC, numerous Congressional committees with financial and regulatory oversight, and certainly not the heads of the financial institutions that failed or required a federal government orchestrated ‘bailout' to stay in business. To simply chalk it up as a Black Swan event is an intellectual copout that concedes an unacceptable level of helplessness in the face of less than mysterious forces. Labeling the largest financial crisis in history as a Black Swan event also provides a degree of absolution to those responsible, who were either blinded by ideology or straightforward greed. The millions of honest hard working people who lost their job deserve better, as do the millions more who work hard and play by the rules. Politicians from both parties and anyone else looking for just one cause for the crisis are missing the bigger picture, and more likely trying to point a finger away from their own contribution. A crisis of this magnitude was not the result of one dynamic. It was a team effort with many contributing players.
With an election coming in November, Congress is highly motivated to show American voters it is enacting legislation in the Financial Regulation Reform bill that will insure a crisis of this magnitude never befalls this country again. Unfortunately, I have yet to hear anyone address what was undoubtedly the most important factor in the crisis. The following chart explains why the crisis was so big, and a fifth grade math student can understand it, and that is not an exaggeration!
Between 1965 and 2000, the median home price was consistently around 3 times median income. During this 35 year period, the U.S. economy experienced a recession in 1969‐1970, 1973‐1974, 1981‐1982, and 1990. Home prices are very sensitive to interest rates, and between 1965 and 2000, interest rates fluctuated wildly. The Federal funds rate jumped from 4.5% in 1965 to 21% in 1981, before working its way down to 5.0% in 2000. The 30‐year mortgage rate rose from under 6% in 1965 to almost 18% (not a typo) in 1981, before dropping to 7% in 2000. It is remarkable that this relationship between median home prices and median income was maintained, despite extreme fluctuations in interest rates and periods of economic recession. It begs the question, How was this possible?
This relationship was maintained because between 1965 and 2000, home buyers were not allowed to buy a home if their mortgage payment was more than 33% of their verified income. The reciprocal of 33% is 3 to 1, which is why median home prices held very close to the 3 to 1 multiple of median income. However, between 2000 and mid 2006, median home prices rose to 4.6 times median income. This was made possible because lending standards were trashed, and prospective home buyers could purchase a home with no money down and without verifying their income. The lax lending standards created an incremental increase in demand that pushed low end home prices up. This allowed the owners of those low end homes to trade up, which set off a chain reaction of trade up demand that pushed mid and upper end prices higher. Some blame the crisis on the Federal Reserve for keeping rates at 1% for too long. The Federal funds rate was 1% between June 2003 and June 2004. After that, the Federal Reserve increased the funds rate by .25% at each of the next 16 meetings. It is almost preposterous to suggest the entire crisis was the result of Fed interest rate policy, after considering the impact lower lending standards had on increasing demand from weak borrowers.
In effort to allow more low income Americans to realize the dream of owning a home, members of Congress pushed Fannie Mae and Freddie Mac into lowering their lending standards. Both firms received lending quotas from the Department of Housing and Urban Development (HUD), and both firms felt obligated to meet or exceed those quotes, which they did. In testimony before the Angelides Commission, which is investigating the financial crisis, Daniel Mudd, former Freddie Mac CEO, said, their ‘standards slipped', as they ‘were balancing against our housing HUD housing goals." Former Federal Housing Finance Agency Director James Lockhart testified that Fannie and Freddie "would have incurred the wrath of Congress if they missed those HUD goals." In 2008, Fannie Mae and Freddie Mac held 56.8% of the $12 trillion in outstanding mortgages. Did lowering their lending standards at the behest of Congress contribute to the increase in home values and subsequent crisis? Absolutely. Fannie Mae and Freddie Mac have been taken over by the U.S. government, and the taxpayers will have to make good on their combined losses of at least $400 billion. It's also worth noting that between 1988 and 2007, Fannie and Freddie made almost $200 million in campaign contributions to Congress. The three largest recipients in the Senate were Christopher Dodd, John Kerry, and Barack Obama.
But to suggest that Fannie and Freddie were the cause of the crisis is an exaggeration, since sub‐prime lending was a big deal in the private sector too. Independent nonbank mortgage brokers originate almost 40% of all mortgages. Since 2007 more than 300 have failed, including Ameriquest, New Century Financial Corp., and Ownit, while Countrywide Financial was acquired by Bank of America. Washington Mutual, the largest bank failure in U.S history, was a big player in sub‐prime lending, and according to the Senate's Permanent Subcommittee on Investigations rewarded loan officers and processors based on how many mortgages they could churn out, and awarded members of the President's Club with lavish all‐expense paid trips to Hawaii and the Caribbean. The emphasis was on quantity, not quality. Lending standards? We don't need no stinking lending standards! After reviewing more than 50 million documents, the Subcommittee determined that borrowers were steered into sub‐prime mortgages, even though they qualified for prime loans, which would have cost the borrower less. But Washington Mutual's brokers made more in commissions on sub‐prime loans. The Subcommittee also found that the bank knowingly included fraudulent loans in mortgage securities sold to investors. I have no doubt that these same practices were duplicated at many of the firms that failed, and some that were bailed out.
Twenty‐five years ago, bank lending was largely dictated by the amount of loans a bank had on its balance sheet relative to its capital base. If a bank could make a loan, and then sell it to someone else, the bank could make more loans, without increasing its capital base or loan reserves. Although the bank would make less money on each loan it didn't hold onto, it could increase earnings, by significantly increasing loan volume. The process of moving mortgage loans off bank balance sheets was initially facilitated by Fannie Mae in the early 1980's. Fannie Mae would buy mortgages from banks all over the country, package them together, and sell them to Wall Street and institutional investors. This was fairly easy to do, since lending standards were fairly strict and uniform, and most mortgages were ‘conventional'.
There are many advantages to the ‘securitization' of mortgages. Borrowers get lower mortgage rates, due to competition. Pension funds and insurance companies are able to increase their investment returns, since mortgage backed securities offer a higher return than Treasury bonds. The success with mortgage securitization has led to the securitization of car loans, credit card receivables, and numerous other assets. This has increased the flow of credit into many sectors of the economy, and until the music stopped in 2007, kept the economy humming. Between 1982 and 2007, our economy was in recession only 16 months. In the 25 years prior to 1982, there were 64 months of recession. A growing economy generates more jobs, a higher standard of living, and a tide that lifts the fortunes of most Americans.
The decline in lending standards however exposed a fatal flaw in the securitization of mortgages. If there are no negative financial consequences when a prospective home buyer can purchase a home with no money down, a mortgage broker can help a prospective homebuyer directly or indirectly falsify data, and a lending institution doesn't have to maintain lending standards if they know they're going to bundle the ‘bad' loans and sell them to be securitized, an open season for fraud and abuse is created. Everyone involved got to make a lot of money, as they shoveled the bad loans to unsuspecting buyers of mortgage backed securities. This type of fraud was allowed to develop over a period of years, while the Federal Reserve, Federal Deposit Insurance Corporation, and Office of Thrift Supervision did nothing.
The decline in lending standards created a wave of additional demand that pushed home prices far beyond their historical relationship with median income. As any fifth grade math student learns, if you have a broad data set and prices temporarily move away from the mean average, values will revert to the mean at some point in the future. In terms of housing prices, this meant that home prices at some point could fall by as much as 33% (from 4.6 to 1, to 3.0 to 1), or slightly less if the decline was stretched over time and incomes rose. The following is a quote from my September 2007 letter. "Between 1965 and 2000, the ratio of the median home price to median household income fluctuated in a narrow range between 2.8 and 3.2. During this 35 year period, increases in home prices were supported by a rise in household income. This relationship provided underlying support for home prices, even when recessions developed in 1970, 1974, 1981, 1990 and 200l. However, between 2000 and 2006, the ratio rose from its long term average of 3 to 4.6. This means median home prices have the potential to fall 33% should the ratio fall back to its long term average. I don't think this is likely. But I'm sure if the average homeowner in Japan was told in 1990 that their home was going to lose 33% of its value, they wouldn't have believed it possible. In fact, real estate values fell by more than 50% in Japan." I discussed this relationship on a number of occasions in late 2007 and throughout 2008. According to the Case‐Shiller Home Prices Indexes, the 10‐city index fell ‐33.5% between July 2006 and April 2009, while the 20 city index lost 32.6%. This reversion to the mean by median home prices should not have been a surprise to anyone. The bust in housing prices was not caused by some mysterious Black Swan event. Just basic mathematics.
S&P, Moody's, and Fitch were in business to be the watchdog, rating the quality of Wall Street offering's of debt, and determining the level of risk for each issue for investors. Unbelievably, the "risk models" used by S&P, Moody's, and Fitch, didn't even include the potential for a national home price decline! Why? Because home prices hadn't fallen nationwide since the depression, they assumed a nationwide decline could and would not occur. Even though housing prices were stretched 50% beyond their long term mean average, the rating agencies were more wowed by Wall Street's financial engineering than basic mathematics. It must be noted that the rating agencies are paid by the Wall Street investment brokers, who sell mortgage backed securities. If one of the rating agencies had refused to provide their standard AAA rating on a batch of mortgages, they risked losing the business to one of the other agencies, who would gladly rubber stamp the pool with an AAA rating. Between 2004 and 2007, the rating agencies received billions in fees from the Wall Street issuers of mortgage backed securities. Could the conflict of interest in this relationship be any more obvious?
I remember in 2004 hearing ads touting loans of 125% of a home's value, and thinking that didn't sound right. I'm sure Alan Greenspan heard some of those ads, but no alarm bell went off in his head. Even when a fellow member of the FOMC expressed his concerns about this type of lending and the Fed's oversight responsibility, Alan decided it wasn't necessary. Greenspan is a true believer in the power of the marketplace to allocate resources far better than any bureaucrat. This is why he allowed the tech bubble to grow, rationalizing that millions of investors knew more than the Fed. The tech bubble
showed that the ‘marketplace' was far from infallible in allocating resources, even if better than a bunch of bureaucrats. Tens of billions of dollars were evaporated when the tech bubble burst, but that didn't dent Alan's faith. It is ironic that the housing bubble, which followed so closely behind the tech bubble, didn't even elicit a raised eyebrow from the Maestro. Greenspan also believed that the enormous increase in derivatives after 2000 would spread risk, making the financial system safer in the process.
In 1999, when the head of the CFTC grew concerned about the unregulated nature of derivatives after the collapse of LTCM in 1998, Greenspan, along with Robert Rubin and Larry Summers, crushed the proposal to increase oversight before it could get off the ground. This opposition to increase oversight and regulation was supported by many members of Congress, who believe less regulation is usually best. Between 2001 and 2009, Rubin received more than $126 million in cash and stock during his eight years at Citigroup. On February 27, 2009, Citigroup needed to receive $25 billion from the U.S government, in large part due to its exposure to derivatives. Contrary to Greenspan's expectation that derivatives would lower systemic risk, unregulated derivatives enabled the virus to spread throughout the global financial system with incredible speed because no one knew their counter party's risk levels.
The investment banks were so confident in their ability to control investment risk, they sought to increase the amount of leverage they were allowed to employ. More leverage would allow them to increase profits, and of course, generate even larger bonuses for themselves. It is not uncommon for an investment banker's bonus to be 500 to 1000 times the income of the average worker. (Is anyone really worth that much more than the average worker?) In 2004, the SEC allowed investment banks to increase their leverage from 12 to 1 to 30 to 1. Leverage unfortunately works both ways. In good times, $30 of borrowed money increases profits, but if an investment loses just1%, $30 is lost. Not much of a margin for error, even for Master's of the Universe. Place a few big bets on an overpriced asset, as housing was in 2005, 2006, and early 2007, a decline of 30% in the underlying asset burns through capital very quickly.
Not satisfied with the amount of leverage they were permitted to use by the regulators, the big banks also established off balance sheet entities that allowed them to book fees from structured investment vehicles, but not set aside any reserves that are normally required for a bank. When the first shock waves spread through the financial system in August 2007, Fed Chairman Bernanke didn't even know these SIV's existed. This says as much about the subterfuge used by the big banks as it does about the lack of oversight exerted by the Fed and FDIC.
Too big to fail is capitalism's kryptonite. Capitalism depends on creative destruction, even when it is self inflicted. If poorly managed firms are not allowed to fail, the overall economy is burdened. The cost to our society for mismanagement, as executed by investment banks, behemoth banks, insurance companies, and supposed non government agencies, will run into the trillions of dollars, and take a generation to recover from, if we're lucky. Whenever the subject of breaking up the banks and investment banks is raised, the standard response from executives is that their immense size provides the economies of scale required to achieve efficiencies that benefit the overall economy. As financial firms grew over the last 15 years, most of the realized efficiencies were passed along to the shareholders of the public companies, included in the large bonuses paid to executives, with the remainder distributed to consumers via lower costs. The ‘efficiencies' are a pittance to what their poor judgment has and will continue to cost our society. They may not like the changes we need to make, but as the saying goes, they earned it the old fashion way by screwing up so badly.
CONCLUSIONS
If the lending standards that had weathered so many changes between 1965 and 2000 been preserved, median home prices would have held near the long term 3 to 1 average of median income. The economic downturn would have been much shallower, despite the 30 to 1 leverage and derivatives. The economy may have still experienced a recession, but a full blown financial crisis would not have erupted. The severity of the crisis was driven by the nationwide decline in home values, which was only made possible by the additional demand generated by the virtual elimination of lending standards, and ridiculous leverage on an overpriced asset. Strict adherence to the old lending standards will also significantly reduce the opportunity for fraud by borrowers, mortgage brokers, and lenders.
Allowing prospective home buyers to purchase a home with no money down invites irresponsibility, since they are risking almost nothing. Home buyers need to put at least 5% down, and the down payment cannot be borrowed from a government agency, ie. FHA. If a home buyer realizes they could lose money, they will be more careful not to overpay for a property, and more conscious of their ability to make their mortgage payments.
The securitization process needs to be modified so that any mortgage originator is required to hold 5% of the loan on their books, and be second in line behind the homeowner to absorb any loss beyond the down payment of the home buyer. A financial disincentive to the mortgage originator for not maintaining their lending standards might provide more persuasion than the ‘threat' of regulatory oversight. As we have painfully learned, it isn't always the lack of regulation, as it is the absence of proactive oversight. During the last 10 years, every regulatory body - the Federal Reserve, FDIC, Office of Thrift Supervision, and numerous Congressional committees were MIA, or worse, complicit.
The rating agencies need to be compensated by the buyers of the securities they are rating, and not by the issuers. This will remove the built in conflict of interest that now exists. S&P, Moody's, and Fitch may not like it, but this change may force them to do a better job in the future.
In 2008, Fannie Mae and Freddie Mac held 56.8% of the $12 trillion in outstanding mortgages. Today, Fannie and Freddie, along with the Federal Housing Authority FHA represent more than 90% of all mortgage activity. The U.S. government has effectively doubled down on the bets it made through the GSE's. The ceiling of $400 billion in estimated losses to be covered by the American taxpayer was lifted late in the afternoon on Christmas Eve 2009. Interesting timing. A proposal in 2003 to increase the supervision of Fannie and Freddie was squashed by those who wanted more lending for affordable housing. As Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee said, "These two entities ‐‐Fannie Mae and Freddie Mac ‐‐are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing." Going forward, Fannie Mae and Freddie Mac cannot be used to achieve a political agenda, and need to be dismantled, even if it takes 10 years.
Total U.S. GDP is roughly $14 trillion. At any given time there are $40 to $60 trillion or more of derivatives floating around, and no one knows who owns how much of what. Forty years ago, over‐thecounter stock options were standardized, so they could be traded through a clearing house and on exchanges. The same thing must happen with derivatives. Period. The five largest investment banks - Goldman Sachs, Citibank, J.P. Morgan, Morgan Stanley, and Bank of America - dominate the derivatives markets and make a ton of money doing it. They oppose the clearinghouse/exchange solution, since it will reduce their revenue and profits. Adapting to this change will give them the opportunity to show how smart they really are! If this is not included in the final financial reform bill, we will all know that the Big 5 have seen a nice return on their campaign contributions and lobbying efforts.
We must take whatever action is necessary to prevent too big to fail from ever bastardizing capitalism again. Even if it takes 10 years to accomplish. The goal is more important than the process used to achieve it. If every financial institution that trades derivatives is required to trade through a clearing house or exchange, the level of transparency would increase dramatically, and lower the need to break up the ‘too big to fail' entities. If every financial institution is prevented from setting up off balance sheet entities, and the regulators do a much better job, a clearer picture of the real financial health of each institution would emerge. Creating a $50 billion reserve fund combined with measures for far greater transparency may be enough.
We have learned a lot about how the crisis came to be and the necessary solutions to prevent anything similar from befalling us in the future. In the coming weeks and months, we will see if change we can believe in becomes a reality, or whether money and power is allowed to conduct business as usual.
The housing bust: A statistical portrait
Percentage of mortgages bundled into securities 55.8% in 1994 74.2% in 2007 Percentage of subprime mortgage packaged into securities 31.6% in 1994 92.8% in 2007 Percentage of mortgage originations that were subprime 4.5% in 1994 20.1% in 2006 Share of mortgage originations by federally regulated savings
29.8% in 1987 8% in 2006 institutions Share of mortgage originations by less‐regulated mortgage 58% in 2006 20% in 1987
brokers Average annual rise in home‐price value 3% 1990‐1999 8.6% 2000‐2006
U.S. home‐ownership rate 63.5% in 1985 68.2% in 2007 4.6% in 2006
Ratio of median home price to median household income 3.2 in 1985 137% in 2007 Household debt as a percentage of disposable income 74.9% in 1985 13.7% on subprime Foreclosure rate on mortgages issued between Jan 1999 and 2% on prime loansJuly 2007 loans
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