Financial Crisis Explained: The Joe Intili Version

This is a follow-on to the previous post.  I offer this explanation as the "Joe Intili Version" because it comes from research and reading done over the several hours since that post, and because it is my summary and conclusions based on that reading.  Per the previous post, I find it remarkable that something which is supposed to be a "crisis" does not have a defining description anywhere, it seems; rather, particularly in Washington, it has a chorus of individuals seeking to blame one cause or another in the hope of advancing one political agenda or another, or just simply to cover their respective backsides.  This post is my attempt at an explanation for how and why the problem occurred.

But, before that, what is the problem?  It is a liquidity crisis - basically, an increased difficulty in getting cash in the form of short-term loans, the kind businesses use all the time to counter short-term fluctuations in their cash-on-hand, i.e. in their cash flow, brought about by business-cycle fluctuations which are daily and inevitable.

Ok, so then why is it becoming increasing difficult for businesses to get these kinds of loans?  Well, typically a business will ask the bank it typically deals with for this kind of loan.  If that bank's cash position (capital requirements for same) are such that the bank cannot make the loan itself, even if this business has a very good credit rating and plenty of collateral, then it will seek a short-term loan from another bank.  Banks do this all the time, but a bank's financial rating is key to getting the loan.  And a bank's financial rating (e.g. from a rating organization like Standard and Poor, quite ironically named) is based on the quality of its assets.  Many currently troubled banks are in trouble because they are holding large MBS assets, i.e. mortgage-backed securities, which rating organizations are finally getting around to dropping below investment-grade, when their initial ratings were misguidedly at investment grade.

Lowering an asset's rating can trigger a whole domino effect of bad outcomes, and it's why getting the rating correct the first time is key.  So many payment streams (mortgage-holders making payments, or rather, not) backing MBS assets are foreclosing that everyone - the rating organizations who rate the assets, and those poor buggers holding them - realizes now that they were/are substantially over-valued.  Banks in need of cash can't unload them at anything near what they paid - so they can't get cash that way - and other banks with cash to loan are reluctant to loan it to these troubled banks because their overall financial rating is now too low.  Such over-valued securities are being called "illiquid", and there are literally trillions of dollars 'em in the banking system, and with Fannie and Freddie, more than enough to "clog the arteries" of the financial system, as some are saying.

Hence, the current liquidity crisis.

Why/how did it happen and who is responsible?

I see five things which interacted to bring about the crisis:

1. A 1995 regulatory rule change under Clinton which allowed for higher borrowing limits on CRA loans (loans to poorer and often minority borrowers under the Community Reinvestment Act of 1977), and also for the securitizing of those loans (the repackaging and selling of the loans as securities, a trend which started in the 1970s with Ginne Mae, and exploded during the housing boom of the last 10 years or so).
2. Insufficient regulation around loan securitization to guarantee that (a) specific underwriting documentation on the credit-worthiness of the borrower was collected, and (b) that such underwriting documentation was forwarded to and considered by the rating organization in rating the mortgage-backed security.
3. Moral hazard on the part of securities rating organizations like Standard and Poor.
4. Actions by the Fed to steadily lower interest rates following 9/11, and keep them there, fueling the housing boom.
5. A lot of hope and greed on the part of borrowers, fueled by persistently low rates and rising real estate values.

I'm going to address these in backward order.

Low interest rates ever create a boon in mortgages and therefore new-home construction.  Such was the case after 9/11, when the Fed slashed rates in response to the economic downturn and instability following the attack.  But rates were kept low.  Lots of folks concluded it was a good time to "trade up".  The demand-push caused a predictable inflation in home prices, and an explosion in new-home construction.  It also encouraged people to buy homes as a speculative investment, hoping to sell or "flip" the homes, as the case may be, in a relatively short period of time in order to cash in on their nicely appreciated values.  Further, both speculators and those who planned to live in these homes were more willing to accept a riskier adjustable-rate (ARM) or sub-prime loan if they didn't meet the underwriting criteria for a traditional, fixed-rate loan, because they assumed the increased equity of the home due to appreciation would qualify them to refinance to a traditional loan within a short period of time.  The dramatic increase in new-home construction (loans were cheap for builders too, don't forget) eventually produced a glut of new homes which had a retarding influence on the sale of existing homes, until the price bubble leveled off and began to fall.

Because of low interest rates and the 1995 CRA rule change, and the general purpose of the CRA, which is to see that under-served areas are served and receive an equitable number of mortgages, yet without sufficient safeguards against defaults, more and larger CRA loans were made, and more of these were ARM or sub-prime, too, the motivations of these borrowers being no different than other borrowers, to buy more home now without the necessary equity for a traditional loan, and refinance to a traditional loan once the house quickly appreciated.

The practice of securitizing loans increased steadily, and especially after the 1995 rule change, the motivations on the part of the originating banks (a.k.a. "the originator") being (1) profit-taking on payment streams (the loans) so that they could enhance their capital, meet capital requirements for writing more loans,  write more loans, and repeat the process, and (2) to shed the risk of writing so many loans at low historic interest rates which might prove too low to cover the default risk, especially given the increased appetite of borrowers for ARMs and sub-primes, and the increased number and size of CRA mortgages.

Because, with securitized loans, the loan risk is transferred from the originator to the purchaser of the security, the security can only be properly priced if such risk is evaluated and underwritten with every bit as much care as if the originator had held and retained the risk for the life of the loan.  Regulations and enforcement thereof for collecting proof-of-income and other types of underwriting documents are not as critical if the institution which loans the money is also the institution which shall hold the loan.  It is self-interest to underwrite something like that thoroughly and well.  But, with securitization, where the originator only writes the loan and then repackages it and sells it to others as securities, where the security-holders now hold that risk, there exists the moral hazard on the part of the originator to not underwrite as carefully - or barely to underwrite at all.  Purchasers of those securities instead rely on the financial rating given the security by a rating organization like Standard and Poor.

So, then, do the originators collect even a sparse underwriting dossier and provide that to the rating organizations to use for rating the security?  I don't know.  I'm not sure what they typically provide or don't.  I assume they provide some info, but not enough, since it's not their problem, and there were not sufficient regulations to make them.  But why wouldn't rating organizations demand such information?  Obviously they didn't, because they consistently and dramatically over-valued these mortgage-backed securities.  And based on their inflated ratings, investors purchased them, and in large numbers, and hence the crisis.  My guess is they didn't demand such info at least in part because they trusted that underwriting of a kind which had been historically done had in fact been done by the originator, when such motivation had deteriorated substantially knowing the loans would be securitized.  Further, rating organizations fell prey to the moral hazard presented by both the existence of competition between rating organizations, and the fact that they are paid by the institutions which wish to be rated, or have their securitized offerings rated.  If Standard and Poor gives a bad rating to an MBS offering from Bank of America, or from Lehman on behalf of Bank of America, how likely is Bank of America to switch to one of Standard and Poor's competitors the next time they need a rating?  Well, quite good, I should think, and so the tendency with these ratings was clearly to error on the high side.

These things all conspired.  So, if wishing to assign presidential blame (in roughly chronological order):  (1) you have Carter, who, under CRA, twisted the arms of banks at the time to write more loans to poorer, less-qualified buyers without any funding mechanism for an inevitably higher risk of defaults; (2) you have Clinton, who allowed for a substantial increase in the size of CRA mortgages and allowed for them to be securitized; (3) you have Bush, who pressed the Fed for lower interest rates after the 9/11 attacks, and did everything possible to keep them there, including doing his federal borrowing from foreign countries like China, including every dollar appropriated for the wars in Iraq and Afghanistan, fueling the housing bubble which then exposed the regulatory flaws in securitized mortgages; (4) you have to a lesser extent, Clinton (second term), and a greater extent, Bush (both terms), who presided over an explosion in securitized mortgages which were under-regulated and poorly underwritten, given that, under securitization, regulation insuring strong, documented, and transparent underwriting and accurate ratings by rating organizations is absolutely key to a healthy market, and that a lack of such regulation permits the inevitable degradation in underwriting which attends a decoupling of those who approve the mortgage from those who hold the mortgage; (5) you have a whole host of presidents for allowing an obvious moral hazard to exist with the rating organizations, where those they rate are also their paying customers; (6) and lastly, you have a lot of optimism and greed on the part of home buyers, that they could speculate with their home purchase, and flip the home or take the low teaser rate and refinance to a traditional mortgage once (and if, but they didn't really consider that) the home quickly appreciated in value.

I feel better now, as I feel like I have some handle on this.  The several hours were worth it.  Because now I know that the bailout proposal which comes down from on high must address at least those things.  Let's be sure it does, and be prepared to scream and holler at our Congressman if it does not, in addition to the added requirement which derives from the bailout itself, that it well look after our $700 billion.

Comments

[James Gordon]

No bailout: LET THEM DIE

It's simple. Unregulated lenders gambled with other people's money and sold garbage with the promise that it was gold. Buying toxic waste will just come around to make us all sick a second time. While the people who did not take their money and run, can now go out and take our money and run. Or, buy a new, gold-plated, antique boat anchor for their yacht.
Instead of a "bailout," - why not do a "break-up?" Why not divide up AIG into 50 little companies with so much oversight that we have an internet camera portal in the mens room?
Just because the press buys into the lies of Secretary Paulson, (who used to run one of the firms that stole pension funds), do we? After all, we do expect Mr. Paulson to look after his friends, don't we?

[Joe Intili]

"Why not divide up AIG into 50 little companies with so much oversight that we have an internet camera portal in the mens room?"

Hysterical.

True.

I am a believer in the phrase I heard (and, of course, appropriated) that if these companies are too big to fail then they are too big to continue.

Very few government plans have been more obtusely explained than this "rescue plan", as the administration is trying to get folks in the media to refer to it (rather than "bailout").

The trouble with doing nothing (the "let them die" approach) is part of what has been so poorly explained. Credit is locked up because financial institutions can't value these MBS with any confidence. A bank can't readily state its assets, therefore its capital, therefore it can't know, and other banks can't know, whether or not it meets the capital requirements (under law) for both lending further or being loaned to. The "illiquid" MBS are clogging up the whole system. If it doesn't unclog, regular companies all around the country who use the banking system for spot loans, short-term loans to balance out their cash flow, like when they need to make payroll, won't be able to get them. Hence, no payroll.

Take that to a large enough scale, and now folks who never engaged in sub-prime loans or lending will end up defaulting on THEIR mortgage payments, and every other bloody payment, and now the entire economy becomes a car wreck, where commerce then moves painfully slowly, until all the banged up vehicles can be sorted out and moved out of the way.

So, we need the damn rescue plan. And I acquiesce to that term only because it's not a bailout in the true bailout sense. The government is going to use the money appropriated under the plan to buy a bunch of these MBS, and thereby trade T-Bills for MBS, and thereby unclog the system. But the government will buy those MBS at pennies on the dollar - perhaps at 1/3 or 1/2 price - and hold onto them until the real estate market rebounds. They will then sell them in the market place. In the end, they will get a significant portion of the $700 billion back, might break even, and could even add additional "profit" to the treasury, as this was the outcome from a similar recovery plan implemented for the S&L crisis of some years ago.

The key thing...after stepping in to address the crisis, and once no longer a crisis...is to implement the oversight and regulation which allowed for borrowers and mortgage lenders to go down this road in the first place. They will need an Internet camera up their backsides if that's what it takes. And that's where some true leadership and legislating will be absolutely key. And part of THAT answer might be making sure we don't have any behemoth AIG companies, but 50 smaller ones.

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[school_dubl]

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