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Tuesday, May 29, 2012

Chain of Blame: An Excellent Primer on the Financial Meltdown

Goodreads | Eric_W Welch (Forreston, IL)'s review of Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis:

Truly a fascinating account of the financial meltdown. It also contains one of the clearest explanations of credit default swaps and collateralized debt obligations I have seen anywhere else. A big problem was that sub-prime mortgages had become a cash cow for Wall Street. Mortgage entities like Countrywide sought out subprime mortgages because they brought higher interest rates, could be collateralized with real estate, and then could be securitized and resold and then added to CDOs which were insured again. At each step of the process, especially as the bonds got larger and larger, the fees collected by the agents and sellers got bigger and bigger and huger and huger. And no one worried because real estate never went down, right? At least not since the great Depression, right? And they were all insured, anyway, right? And we're making so much money. Right.

It astonished me to see the effect language could have on the market which then cascaded into larger problems. When the president of Countrywide said in 2007 he didn't think we would pull out of the recession until 2009, shudders ran through Wall Street, and when he actually used the word depression, it tumbled head-over-heels. By that time Countrywide had 15% of the market for subprime mortgages and wanted 20%. They were making sooo much money. Then he opened his mouth and the slide began.

Again, there were many causes for the current crisis and some resulted from unintended consequences. For example, in 1986 Reagan and Congress pass the Tax Reform Act that eliminated the tax deduction for personal finance interest on credit cards, car loans, etc. It was a subtle kind of tax increase and was intended to raise revenue and lower the deficits. That's what happened at first until mortgage finance companies realized they could promote second liens on homes by loaning money on the increased equity of homes. All would go well assuming that houses increased in value. Some finance companies even made loans on 125% of a home's value.

The advent of loan brokers was another contributing factor. These were folks who acted as intermediaries between the borrower and the finance company (by this time finance companies had eclipsed banks and savings and loans as mortgage originators, primarily because they could charge more interest since they were not regulated the way banks were.) The problem was that brokers made money by financing and refinancing. It was in their interest to get homeowners to constantly refinance because their only source of income was generated as points on the loan. This made predicting income over the life of a loan very difficult and the securitization of the loans was based in part on expected performance of the loans, which became almost impossible and was wildly optimistic.

Ironically, in another of those unintended consequences, the closing of numerous savings and loans after the S&L crisis threw many experienced mortgage managers and brokers out looking for jobs and places like Country-Wide snapped them up. Of course, they had to start writing mortgages. Another was the California Nolan Act, passed in 1983, that permitted federally chartered S&Ls to invest 40% of their assets in non-residential real estate. Entrepreneurs and developers would purchase an S&L and then use its capital to fund their own building projects. Nolan had been a pal of many S&L executives, and his act opened the door for unscrupulous folks to channel consumer savings into all sorts of projects. S&Ls began to fall like dominoes.

All of the constituent parts of the current crisis were available to review had anyone taken the time to look at the S&L crisis: deregulation of a successful business but one seen as under-performing, interference with regulators by Congress, federal subsidization of loans, reduction of the number of regulators, media cheer-leading (CNBC was then called the Financial News Network, but the role changed little), and finally collapse and massive government bailout: $150 billion in 1980 dollars or the equivalent of about $450 billion today. (Sound familiar?)

I often hear from my conservative friends that if it weren’t for those people getting mortgages they couldn’t afford, we wouldn’t be in this mess. So let’s see. You go to a mortgage lender (bank’s were in the minority in offering mortgages,) because you’ve seen an ad on television. The lender asks how much money you want for your house. You tell him/her. They ask how much you earn. You state what you earn. And you get the loan. So who’s the idiot in this scenario? The person asking or the lender loaning? Lenders would forge appraisals to get higher values for the houses since the higher the mortgage the bigger the fee. And they certainly did not care if the mortgage was repaid since they were sold and securitized immediately.

Here’s how it worked at one company: New Century. Started by four out-of-work executives (they moved a wall so that each would have exactly the same size office since they gave each of themselves the title of President and CEO) they created a business specializing in subprime mortgages which were extremely profitable since they always carried a higher interest rate. In a time of cheap money that was crucial. They convinced Solomon Brothers to loan them $105 for each $100 in loan originated (this was unusually high since usually a loan business should be able to run on $3 per hundred.) The loans were made, usually without regard to the creditworthiness of the borrower because it didn’t matter. They would collect the fees and resell the loans to Wall Street which would then securitize the loans, sell them in packages offering high interest rates which made them very attractive to investors, and which were then further insured by companies like AIG. Everything went along fine as long as properties continued to increase in value. Borrowers would refinance every couple of years, taking out the equity, and buying more property. Inevitably, as all bubbles must, the balloon burst and when borrowers couldn’t refinance at a higher loan value and balloon mortgage came due, everything came tumbling down and you and I bailed out Wall Street which had so encouraged this kind of risky behavior.

A must read.

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