UPDATE: A bit of good news for a change. The Credit Default Swaps are working. Of course, now that they are working, Senator Harkin wants to ban them.
Sen. Tom Harkin, who has proposed banning these swaps and last week introduced a bill to regulate them. “With the value of swaps at a high of some $531 trillion for the middle of this year — 8½ times the world GDP of $62 trillion — it is long past time for accountability in the markets,” he said. The notional amount of the credit default swaps got as high as $62 trillion, with the rest of Sen. Harkin’s estimate coming from other financial transactions. “Shouldn’t we just outlaw all of these fancy little things?” he asked.
Of course. We wouldn’t want it to get out that the real problem was CRA.
The current housing collapse and associated financial meltdown were the consequences of a bubble. There has been considerable analysis of how this happened. We had low interest rates, a government program to increase home ownership and a delusion that housing prices could only go up. In addition to those mechanisms, we had a drive for high yields and resulting extreme leverage in the financial services industry. Something similar to this occurred in Orange County, California in 1994 when the county Treasurer got caught in a classic short squeeze while investing in bonds and their options. He was betting on an arbitrage between short and longer terms rates. When rates rose, his investments fell in value. Unfortunately for the County, the investments were highly leveraged and the fall in value triggered what in effect was a margin call.
What happened in the housing and financial markets was similar.
At the end of 2004, Eisman, Moses, and Daniel shared a sense that unhealthy things were going on in the U.S. housing market: Lots of firms were lending money to people who shouldn’t have been borrowing it. They thought Alan Greenspan’s decision after the internet bust to lower interest rates to 1 percent was a travesty that would lead to some terrible day of reckoning. Neither of these insights was entirely original. Ivy Zelman, at the time the housing-market analyst at Credit Suisse, had seen the bubble forming very early on. There’s a simple measure of sanity in housing prices: the ratio of median home price to income. Historically, it runs around 3 to 1; by late 2004, it had risen nationally to 4 to 1. “All these people were saying it was nearly as high in some other countries,” Zelman says. “But the problem wasn’t just that it was 4 to 1. In Los Angeles, it was 10 to 1, and in Miami, 8.5 to 1. And then you coupled that with the buyers. They weren’t real buyers. They were speculators.” Zelman alienated clients with her pessimism, but she couldn’t pretend everything was good. “It wasn’t that hard in hindsight to see it,” she says. “It was very hard to know when it would stop.” Zelman spoke occasionally with Eisman and always left these conversations feeling better about her views and worse about the world. “You needed the occasional assurance that you weren’t nuts,” she says. She wasn’t nuts. The world was.
This was bad enough. What happened with those mortgages after they were written was worse.
Enter Greg Lippman, a mortgage-bond trader at Deutsche Bank. He arrived at FrontPoint bearing a 66-page presentation that described a better way for the fund to put its view of both Wall Street and the U.S. housing market into action. The smart trade, Lippman argued, was to sell short not New Century’s stock but its bonds that were backed by the subprime loans it had made. Eisman hadn’t known this was even possible—because until recently, it hadn’t been. But Lippman, along with traders at other Wall Street investment banks, had created a way to short the subprime bond market with precision.
Here’s where financial technology became suddenly, urgently relevant. The typical mortgage bond was still structured in much the same way it had been when I worked at Salomon Brothers. The loans went into a trust that was designed to pay off its investors not all at once but according to their rankings. The investors in the top tranche, rated AAA, received the first payment from the trust and, because their investment was the least risky, received the lowest interest rate on their money. The investors who held the trusts’ BBB tranche got the last payments—and bore the brunt of the first defaults. Because they were taking the most risk, they received the highest return. Eisman wanted to bet that some subprime borrowers would default, causing the trust to suffer losses. The way to express this view was to short the BBB tranche. The trouble was that the BBB tranche was only a tiny slice of the deal.
But the scarcity of truly crappy subprime-mortgage bonds no longer mattered. The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.
The arrangement bore the same relation to actual finance as fantasy football bears to the N.F.L. Eisman was perplexed in particular about why Wall Street firms would be coming to him and asking him to sell short. “What Lippman did, to his credit, was he came around several times to me and said, ‘Short this market,’?” Eisman says. “In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’”
The total amount of financial paper based on the mortgages far exceeded the actual value of the mortgages themselves. If all the mortgages went to zero, that would not be the end of it. There was still paper out there that had no basis in reality. There were no assets behind it.
The housing bubble still went forward.
More generally, the subprime market tapped a tranche of the American public that did not typically have anything to do with Wall Street. Lenders were making loans to people who, based on their credit ratings, were less creditworthy than 71 percent of the population. Eisman knew some of these people. One day, his housekeeper, a South American woman, told him that she was planning to buy a townhouse in Queens. “The price was absurd, and they were giving her a low-down-payment option-ARM,” says Eisman, who talked her into taking out a conventional fixed-rate mortgage. Next, the baby nurse he’d hired back in 1997 to take care of his newborn twin daughters phoned him. “She was this lovely woman from Jamaica,” he says. “One day she calls me and says she and her sister own five townhouses in Queens. I said, ‘How did that happen?’?” It happened because after they bought the first one and its value rose, the lenders came and suggested they refinance and take out $250,000, which they used to buy another one. Then the price of that one rose too, and they repeated the experiment. “By the time they were done,” Eisman says, “they owned five of them, the market was falling, and they couldn’t make any of the payments.”
But that wasn’t the end of it.
Moses actually flew down to Miami and wandered around neighborhoods built with subprime loans to see how bad things were. “He’d call me and say, ‘Oh my God, this is a calamity here,’?” recalls Eisman. All that was required for the BBB bonds to go to zero was for the default rate on the underlying loans to reach 14 percent. Eisman thought that, in certain sections of the country, it would go far, far higher.
Thus, the financial paper based on the mortgages far exceeded the amount of the purported assets backing them. Well, that collapse has occurred. What do we do now ?
Laurence Lindsay has a suggestion.
It is quite natural for politicians to seek to target benefits on those that they perceive to be in need. It is the normal political response to the wheel that is squeaking the loudest. Regardless of motive, the reality is that these programs and indeed the bailout’s whole approach is failing. Even Treasury Secretary Henry Paulson has now thrown in the towel on his original proposal to buy bad assets from the troubled financial firms: the Troubled Assets Relief Program (TARP). None of the $700 billion targeted for TARP will be used as originally intended. Instead most of it will prop up the capital position of the troubled financial institutions, allowing them to hold existing portfolios of questionable loans on their books. The rest will be spent on other distressed firms and troubled markets.
What else could be done ?
Hundreds of billions of dollars later, we are left with the same three underlying economic problems the economy faced when the bailout was proposed. First, the troubled housing-related financial assets that TARP was supposed to move onto the government’s books are still in the private sector, while the nation’s banks rush to pare down their balance sheets in the only way they can–by recouping existing loans and not making any new ones. Second, the housing market continues to fall–prices are down 22 percent from their peak and dropping roughly 1 percent per month. Housing starts are at a 17-year low, and homebuilder confidence is the lowest ever recorded. Third, with unemployment rising and consumer credit tight, household cash flow is in desperate shape. If it doesn’t stabilize, the odds are high that the current recession will wind up being as bad as, or possibly even worse than, the deep recessions of 1974-75 and 1980-82.
Try something new ?
The country faces three major economic problems: (1) making liquid the troubled housing debt that is clogging up the books; (2) stabilizing home prices; and (3) improving household cash flow. Each can be more easily achieved by rewarding virtue than by continuing down the current path.
The government should offer the option of a new mortgage to everyone now holding one, be it from a Government Sponsored Enterprise like Fannie Mae and Freddie Mac, a bank, or a mortgage broker. The principal amount would be the same as the existing mortgage. If the home-owner had two mortgages or a home equity line, they could all be rolled together into one new 30-year fixed rate mortgage. The new mortgages should have a substantially lower interest rate than existing mortgages. I suggest 4 percent, but the rate could be slightly higher without affecting the program.
This is a bit like the proposal McCain made during the campaign with one big exception. It would be offered to homeowners who are NOT in danger of foreclosure. It would be offered to everyone but with one significant provision. It would be a “recourse loan.” You would have to repay it even if your house sold for less than the amount of the loan. Recourse loans were common when I bought my first home. It never occurred to me that I could walk away from the home. The other provision would be that the loan would be assumable, another feature of mortgages 40 years ago.
The new mortgage would have one very significant difference: It would be a full recourse loan. That is, if the borrower fell behind in the payments, the government could use any means necessary to get repaid. That means not only foreclosing on the house (as under current mortgages) but also collecting any remaining unpaid sums after the house was foreclosed on by garnishing the wages, bank accounts, and other assets of the borrower. Think of it as the IRS providing the loan on the same collection terms as it does on taxes, or perhaps using the powers the government now has to collect on student loans.
The new mortgages are aimed at people who really plan to remain in their homes. There would be no incentive to accept if the homeowner is planning to move on and sell the home soon.
Homeowners facing some economic distress but who otherwise would like to stay in their homes, even though the price was below the mortgage, might still find it attractive to take the new financing deal. For example, anyone with a 6 percent mortgage would see a 200 basis point drop in the cost of carrying a home. On a $200,000 mortgage, that would be a saving in principal and interest of $244 per month. (The monthly income of that homeowner is usually in the $3,000 to $4,000 range, so this is a significant saving.) In addition, the monthly payment would likely go down even more on loans that have been in place several years since the principal repayment period would once again become 30 years. If the homeowner is about to face a balloon repayment on a home equity line or an interest-rate readjustment under a variable rate mortgage, the new mortgage terms might make the difference between being able to stay in the home and facing foreclosure.
The key is that homeowners would have to make the choice. Only the homeowner knows whether he or she will be likely to stay in the house and repay the mortgage or be forced to give it up. Under the current arrangements, the homeowner has no incentive or need to signal his or her intentions.
What is the benefit of such a program ?
Given the risk-averse nature of current markets and the lack of any real information, it is likely that the market price of the mortgage pool is well below the actual likely outcome. But no one knows for sure. As a consequence, Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDOs) are clogging up the financial system.
Under the refinancing option, this problem goes away. The world is divided into two sets of homeowners: those who think they will repay and those who don’t. Those who think they will repay take the new government mortgage. The old mortgage is repaid. All of the MBS and CDOs in the system therefore face immediate full-dollar repayment of all the “good” loans in the mortgage pool. Everything that is left can pretty much be written down to pennies on the dollar. The uncertainty regarding securities pricing is gone. Banks and the financial markets know with a good deal of precision what each security is worth. In fact, they are handed a series of checks for the bulk of the true value of the security as the wave of refinancing works its way through the system. Thus, not only is the uncertainty removed, but the entire financial system is liquefied.
Thus the mortgage market is divided into two groups; those who will stay in their homes and who will repay their mortgages, and those who will not. The first group has a low default rate, the second is probably worthless. It doesn’t solve the problem of all the Credit Default Swaps floating out there but they are lost anyway. The market can resume to function. It sounds to me like a good idea.
