Friday, May 10, 2013

The Mess in the US - Part III

In the first two parts of this series, we covered the rise of securitized loans and birth of credit default swaps. We left off in the throngs of a raging bull market being driven by a new era of technology companies. With the exception of a few hiccups, Wall Street has prepetuated almost 20 years of wealth creating, bull market returns on the backs of financial leverage, innovation, and good ol' fashion greed.

The booming 90's came to a screeching halt at the turn of the century, when the "dot-com bubble" finally burst. Technology stocks, especially anything even remotely related to the Internet, were trading at astronomical valuation levels on pure speculation that at someday in the future these dot-com companies would be making loads of cash. Once the market realized that "the emperor has no clothes," investors bolted for the door, yanking the much needed capital (money) that non-profit producing start up companies needed to survive. During this time, some companies like Enron, WorldCom, and Tyco were exposed for investor fraud and eventually went bankrupt. In the midst of all this, the US also suffered it's first attack on US soil since the bombing of Pearl Harbor in 1941. It was a dire time for many Americans as the US was slipping into a recession and fear of another terror attack weighed on people's hearts and minds.

In an attempt to stimulate the economy, the Federal Reserve Bank (commonly know as "the Fed") systematically slashed the Fed Funds rate all the way down to 1%. To give some background, banks are required by law to maintain a certain level of reserves to back up their portfolio of loans. If they fall below the reserve amount, they can borrow funds from other banks who have excess reserves. The nominal Fed Funds rate is the target interest rate at which banks should lend money to each other and is set by the Fed. The effective Fed Funds rate is the actual rate at which banks lend from each other. The Fed tries to bring these two rates closer together through open market activity (e.g. if the effective rate is too high, the Fed injects more money into the system making it easier to get a loan, so banks have to drop their rates to stay competitive). A bank makes a profit on the spread between the rate at which they borrow and the rate at which they lend out. With the cost of borrowing at historical lows, banks were able to lend out funds at very attractive rates making it extremely easy for people to get their hands on OPM (other people's money).

There was no bigger winner from the Fed's fast and loose monetary policy than the US housing market. With the stock market tanking and the cost of debt at historic lows, money started to pour into real estate markets. Americans started to "up size" their homes and investors began to jump into the market. As the number of buyers started to outpace sellers, prices adjusted upward to match supply with demand (a little econ 101). This in turn attracted more money into the market as people began to flip houses for profit, which added to the demand and further perpetuated the housing market's meteoric rise. Homeowners became "house-rich" and cash poor, so they turned to home equity loans to tap some of this new found wealth. This money in-turn was dumped back into the economy as Americans continued to feed their spending addiction. The spending spree stimulated economic growth, pulled the US markets out of a recession, and put the bull market back on track.

Historically, under "normal" market conditions, the average home owner purchases a home worth three to four times their annual household income. During the peak of this proflict housing boom, the average house sold for five times (a 50% increase) household income with some hot markets along the coasts hitting much higher levels. Housing prices rose to unsustainably high levels, which was perpetuated by both aggressive lending practices and Congressional posturing.

Back in the day, when someone wanted to buy a house they would go to a bank or a thrift for a loan. The lender would then originate the loan, keep it on their balance sheet, and service it until it was paid off or defaulted. The beauty of this simple system is that each lender was keenly aware of the risk they were taking by making loans to each Joe Soon-to-be-Homeowner that walked through the door. But as we've previously addressed, this all changed with the dawn of the securitized loan market. Under the new world of mortgage lending, loan originators were stand alone entities (Countrywide is a good example) who's compensation was more closely aligned to the quantity of loans created rather than the quality.

In order to keep the lending spigot flowing at full blast, loan originators created new, exotic loans that offered stated income, teaser rates, interest only, and balloon payment features. The details of these exotic terms are beyond the scope of this discussion, but all of them tweaked the characteristics of a conventional fixed rate amortizing loan. The primary purchasers of these loans were the securitization firms (mainly Frannie Mae and Freddie Mac) who took the loans, packed them together, and sold them to investors (primarily banks). Packaged loans were being analyzed by outdated computer programs which were not fully capturing the risks associated with these exotic new products. Marc Gott, a former director of Fannie Mae's loan servicing department was quoted as saying: "We didn't really know what we were buying. This system was designed for plain vanilla loans, and we were trying to push chocolate sundaes through the gears." But that didn't stop the machine from pumping out new securitized products backed by "chocolate sundaes." As long as the rating agencies (who's financial interests were also aligned with the number of loans they rated) signed off on the methodology and put a triple AAA rating on the product, securitization firms could sell them with easy and therefore also cared more about the quantity versus the quality of loans they purchased.

Adding to this massive tailwind was Congress pushing both Fannie and Freddie to take more risks and keep the breakneck pace going. Whenever anyone would suggest that Congress rein in the giant pseudo government lenders, lawmakers where hit with a barrage of angry phone calls and letters. One such automated phone call warned, "Your congressman is trying to make mortgages more expensive. Ask him why he opposes the American dream of home ownership." To make matters worse, Wall Street decided to jump into the market as investment banks like Bear Sterns, Lehman Brothers, and Goldman Sachs were cutting Fannie and Freddie out of the loop by securitizing loans and selling them directly to investors. Suddenly, Fannie and Freddie ran the risk of becoming obsolete and failing on their Congressional mandate. Another former senior executive at Fannie Mae was quoted as saying:

Everybody understood that we were now buying loans that we would have previously rejected, and that the models were telling us that we were charging way too little, but our mandate was to stay relevant and to serve low-income borrowers. So that's what we did.

With Congressional support, the sub-prime mortgage market ballooned from $160 billion in 2001 to $540 billion by 2004, a three fold increase in just four years.

Loose monetary policy, aggressive lending practices, speculative real estate investors, and financial weapons of mass destruction had now set the stage for biggest finanical disaster in US history since the Great Depression. We'll explore the wild ride down from 2007 to today in the next and final installment of this series.

Frugal Franco

All quotes taken from The New York Times article entitled The Reckoning.

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