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What you are not being told about the current financial crisis II

Laird Minor, one of our commentariat who has spent a lifetime in this sector of the financial industry felt the first article on the subprime financial crisis gave an incomplete picture. He proceeded to fill in the rest of the story in such fine form that I am re-posting his comment here on the front page so that it will, in conjunction with the first article, give our readers a much better idea of what is going on and what to expect.

Having been a participant in one way or another in the subprime mortgage industry for over 20 years, this is a topic in which I possess a fairly substantial degree of expertise. The first article is reasonably accurate as far as it goes, but there is a lot more to the story. I could probably write a book on this, but I will try to keep this post as brief as I can.

The CRA only applies to banks, and while banks are the originators of a large number of mortgage loans, non-bank lenders have come to comprise a substantial portion of the mortgage industry. This is especially true in the subprime sector. Thus while the CRA was a typically bad Washington idea, propounded by “poverty lobby” zealots with no conception of how the market works, it isn’t really the principal source of the problem. That honor goes to Wall Street.

Subprime loans are not “agency-eligible”, which means that they can not be sold to Fannie Mae or Freddie Mac, the two huge quasi-governmental agencies that dominate the mortgage world. For this reason subprime lending remained a fairly small segment of the market, much like “payday lenders” are in a different market, until Wall Street figured out how to securitize the loans. Securitization is an extremely valuable financial tool, as it allows loans, which in essence are nothing more than streams of cash flows, to be combined into giant pools and carved up into separate “tranches” having different characteristics as to timing, default risk, etc. By separating these cash flow streams the tranches can be sold to different investors with different investment criteria (insurance companies, for example, have clear actuarially-determined timing needs for cash) which results in better pricing. Overall, securitization created a more efficient market for mortgages, which benefited everybody. Unfortunately, it got out of hand, primarily because of the rating agencies and, to a lesser extent, the monoline bond insurers.

Mortgage-backed securities are rated by Moody’s, Standard & Poors, and Fitch, to determine their investment grade. This affects both price and the appropriate universe of investors. As more and more subprime mortgages and especially unusual ones like “pay-option ARM” loans began to be placed into securitization pools, the rating agencies failed miserably in analyzing them and forecasting their performance characteristics. Monoline insurers, who provide bond insurance for the highest-grade bonds, similarly failed to adequately model these loans’ performance, and thus imposed inadequate credit enhancements (loss reserves, subordination levels, etc.) on the deals. Lenders found that they could sell all the loans they booked, with no meaningful penalty for weak credit quality, so of course they expanded their guidelines. They were merely reacting rationally to signals the market was sending, and do not deserve all the blame for the ultimate melt-down.

So the mortgage pools got riskier and riskier, but no one really appreciated that fact until delinquency levels began to surge last summer: there is a fairly long lag time between mortgage origination and delinquency. Once investors realized how bad the pools had gotten they stopped buying the bonds. The market for mortgage-backed securities ground to a halt almost overnight; pricing for existing securities went into free-fall, and new deals simply couldn’t be completed. And since banks and other financial institutions which own most of those securities are required to write them down to current market values, their paper (unrealized) losses ballooned. This is the reason for such events as the Bear Stearns failure; it had pledged those securities for its borrowings, and when the bond values plummeted and the loans were called they could not come up with the cash.

It is a typical Wall Street “bi-polar” overreaction, but the pain is very real. Property values, which had been driven up by speculative excesses and cheap money (as noted in the first article), are falling rapidly, especially in the areas where they had risen the most (Florida, southern California, Arizona, etc.), and until they bottom out the liquidity crunch will continue. Eventually that will happen, though, and when it does things will return more or less to normal. Hopefully the participants in this market will have learned something from the experience, but I am not sanguine about long-term wisdom; Wall Street has a short memory, and the next generation of traders will probably repeat at least some of these mistakes.

So there is blame to go around: foolish laws and regulations; inadequate understanding of the effects of weakened credit standards; a few, but very few, truly predatory lenders taking advantage of unsophisticated borrowers; and greedy borrowers who were speculating in real estate values or who simply wanted to extract all of the equity in their homes for current consumption. In my opinion this last group is getting far too little of the blame. It was a market failure of monumental proportions, but as long as the politicians will stay out of the way the market will correct itself; it always does. Unfortunately, it now appears that politicians, who always want to be seen as “doing something”, whether it makes sense or not, will muck around in matters which they don’t understand and make things worse.

The Law of Unintended Consequences will come back to bite us. It always does.

14 comments to What you are not being told about the current financial crisis II

  • Excellent. Samizdata is invaluable, and not the least it’s commentariat.

  • Perry


    I am the author of the article to which you commented. I would very much like to benefit from your guidance as I do future work on this issue. If you’re willing please contact me at perrywillis at downsizedc dot org. Thanks in advance

  • RAB

    Yes Laird, absolutely superb post.

    Like Alisa, one of the main reasons I love Samizdata is that we can summon up and expert on everything,
    including the proverbial Rocket Science.

  • Laird

    Perry, I will contact you.

  • Dale Amon

    Perry Willis: You might want to chat with Alisa (see first comment) as she is the one who will be translating the article to Hebrew for Israeli distribution.

  • Paul Marks

    That Fannie Mae and Freddie Mac “dominate the mortgage world” shows how far from a free market the United States has gone.

    And sadly Neil Cavuto on Fox News (and other well meaning people) concentrate on preventing things getting any more statist – not on rolling back existing statism. That line (of going along with the status que – whether for dishonest or HONEST motives) has a name, it is called “the long defeat”.

    Of course, even the private financial enterprises are distorted by the endless flow of funny money that comes (in the end) from the Federal Reserve – a flow that means there is a lot of money sloshing about to be lent.

    Borrowing (whether for investment or for consumption) must be 100% financed by real savings – i.e. people choosing not to consume this part of their income on goods or services – but to lend it out instead, to not have the money anymore untill WHEN AND IF they are paid back.

    Efforts to “expand credit” beyond real savings, by whatever means, always end in tears.

  • Plamus

    Efforts to “expand credit” beyond real savings, by whatever means, always end in tears.

    While I would not be as “radical” as Paul Marks – I think there is a legitimate place for leverage and multipliers in the economy – I generally agree.

    Allow me to venture a medium turn forecast.

    For some time now, financial institutions have been writing down assets – “marking them to market” when there is no market for them. There will eventually be market for them, although by no means as big and dynamic as it was up until a year ago – how big and lively will depend to a large extent on how much regulators decide to “Sarbanes-Oxley” it. When the market awakes, some (not all) of those writedowns will be unwound, and show up as “totally unexpected” gains in income statements. I wish I could provide an ETA for this, but I can’t – my best guess is it will coincide or slightly lag an upturn in the real estate market, so I’d guesstimate about middle of 2009. There will be a collective sigh of relief (“We lived through it, it’s over!”), and then giddiness. The cheap money that the Fed is shoveling into the economy will be released, and we’ll see a short bull market that I will not want to miss. But the big question is whether by then the full inflationary effect of Fed’s actions will be obvious. And when it does become obvious, it’ll be ugly… uglier than now.

    To recap, I predict some more pain for 1-1.5 years, then a really happy time, and then inflation, which, as far as I can judge Bernanke (disclaimer: I am no fan of his, as you may have guessed – the guy made a career of studying what the big wise guys should do to prevent recessions, i.e. laissez-faire is not in his vocabulary), the Fed will turn into stagflation. I hope I am just a neurotically insane Cassandra – but this is how I will position my money.

  • Laird

    Plamus’ forecast is a plausible one, and probably the best we can hope for. Still, let me offer an alternative scenario:

    The banks have been forced to mark-to-market many of their mortgage-backed securities, even if they had really intended to hold them until maturity (an artifact of the ill-considered Basel Accords of about 15 years ago, but I digress), which has depleted their capital. Still, most have not yet taken a really hard look at their commercial loan portfolios, and few have them adequately reserved. Many (especially smaller community banks) have large exposures to residential real estate developers, but residential construction is (properly) in the doldrums right now and those developers are in deep trouble. Many of those loans are seriously under-collateralized because they are secured by large tracts of raw land which the banks are still showing at pre-2007 appraised values.

    [An example: I know of a very small (about $350MM in total assets) bank which has about $150MM of such developer loans, all secured by land in Florida. That land is now worth less than one-third of the appraised values, and the loans are seriously underwater, but the bank (which, of course, has taken very few loss reserves against them) is carrying them as performing loans because in many cases they created “interest reserves” at origination. In other words, the bank is paying interest to itself out of a segregated portion of the loan proceeds. Once those interest reserves run out, the developers won’t be able to pay, the bank will be forced to write down those loans to more realistic values, and it will be insolvent. This is a dead bank walking, and there’s not a thing anyone can do about it.]

    As the ripple effects of the subprime liquidity crisis cascade through the economy the bank regulators will look harder and harder at commercial loans. Banks will be forced to increase their loss reserves, sell some loans, bolster their capital levels (such as by reducing dividends and selling stock in a weak market), and tighten up their lending criteria. This will result in less financing available for new projects (“cheap” money notwithstanding), which will push down the value of commercial real estate. (We’re already starting to see this happening.) The overall economy will remain weak for much longer than would otherwise have been the case.

    Also, a fairly large number of banks (mostly smaller ones) will fail. Clearly the regulators are expecting this: the FDIC recently posted for a large number of new hires, and is trying to entice recent retirees back to work. My bet is that upwards of 100 banks will fail within the next year. Insured depositors won’t lose (the insurance fund is quite solvent), but shareholders will. This won’t help the economy, either.

    So, while I hope Plamus’ scenario is correct, I’m a bit more pessimistic and am expecting about 3 to 5 years of unpleasantness. The exact duration, of course, will be proportional to the amount of governmental interference.

  • Laird

    Incidentally, here’s an amusing music video on Ben Bernanke:


  • Midwesterner

    Suing their bank for loaning them too much money. I imagine we’ll see more stuff like this. Meanwhile, there is a big hunk of some of the best farmland around pushed up into piles and riddled with what were to be streets. They were going to build almost a thousand houses here. They’ve built about 20. The RE market clearly was tipping over the edge before they broke ground and they went ahead full steam, damn the signals. Ground isn’t the only things these guys broke. Now they want to break the bank. Literally.

  • Plamus

    Laird, thanks for the link! Tar and feathers for Ben!

    Your scenario makes a great deal of sense – I do agree that we do not know yet how deep the rabbit hole runs, and thus tried to disclaim any time line. The relatively brief bull market I foresee would be nothing but a feast in time of plague, and may not come at all. I defer to your knowledge about the commercial real estate market and loans. What do you think about other collateralized obligations – backed by auto loans, credit cards, insurance (I am not even going to touch CDO-Squared and Cubed products)?

  • Daveon

    But it’s not just the securitization of frankly dodgy loans that was the problem. It was the agencies being allowed to make and mis-sell the loans in the first place who are part of the problem.

    The securitization helped shove the muck under increasingly lumpy carpets but it didn’t take a genius to work out that the insane lending arrangements were going to lead to a nasty hangover at some point.

    Now we’ve got multiple credit problems. We’ve people who should never have been given loans about to be homeless; we have people who refinanced debt into their new sub-prime mortgage who are not only going to be made homeless but have run up even more debt which will be defaulted on; we’ve people who’ve done the former but at least won’t be made homeless but still have to pay off the debt; finally, we’ve huge personal debt that has to stop and get paid down before “normal” spending can be resumed.

    Added to that you’ve got a generation of people who see their home as a wealth generation vehicle and not a home.

    I’m just glad I cleared all debt apart from Mortgage a couple of years ago and have some cash set aside now. I see a lean few years in many places.

  • Laird

    Sorry, Plamus, I disclaim any special knowledge about other types of securitization products. My guess is that auto loan delinquencies, etc., will go up a bit as the economy continues to weaken, but the durations of those bonds are so short that they shouldn’t be too badly affected. CDO’s, of course, are toxic waste, but as you’ve already noted they’ve probably been written down to market value and shouldn’t go much lower. Just my guess, though.

    Daveon, you mentioned several times that people will be made “homeless.” Not true. The houses are still there; only the owners will change, and the fools who borrowed beyond their means will simply revert to what they really were all along: renters. That’s what I call someone who financed 100% of the purchase price, or refinanced to suck out 100% (or more, using inflated appraisals) of their equity. Some people simply aren’t ready for the responsibilities of home ownership, and shouldn’t have gotten mortgages in the first place. If they’re foreclosed upon, since they have no equity they lose nothing; they merely have to endure the inconvenience of moving. It’s unfortunate that the legal system (and meddling politicians) make it so difficult and expensive to accomplish.

  • Paul Marks

    Comrade Clinton said that a person (you know who) who said that neither big banks or small borrowers should be bailed out “sounded like Herbert Hoover” and Comrade Obama agreed (the conflict between Clinton and Obama being a personal one – rather than one of principle).

    In fact (as opposed to in the school history books) Herbert “The Forgotten Progressive” Hoover was a hyper interventionist – and it was his interventions (such as the Washington Conferences to try and hold up wage rates) that turned the crash of 1929 into the Great Depression.

    Without these interventions the ending of the late 1920’s credit-money bubble (the Ben Strong bubble) would have been similar to the end of World War One credit-money bubble in the harsh slump of 1921 – hard times, but wages and prices were allowed to adjust and the economy recovered.

    The man who allowed wages and prices to adjust was President Warren Harding – he did nothing in the face of the slump, apart from cut government spending and taxes.

    This is the real reason that establishiment historians hate Warren Harding – it is not corruption for the Administrations of F.D.R. and Harry Truman were far more corrupt (and the establishment people love those Administrations).

    Warren Harding was polite to Commerce Secretary Hoover (unlike Calvin Coolidge, who said of Hoover “he has given me more advice than any other man – and all of the advice has been bad) but he did not do what he wanted.

    Even in 1981 -1982 President Reagan did not panic in the face of a credit money bubble bursting.

    It is true that the increase in defence spending did NOT help (it was not meant to – it was done for national security reasons, and some other programs were cut which PARTLY made up for the increase in defence spending) but wages and prices were allowed to adjust and the economy recovered (helped by cuts in tax rates – just as Warren Harding had done).

    That is the choice before Americans now.

    Hard times for awhile – or panic interventionism on the line of Herbert (again “The Forgotten Progressive”) Hoover and F.D.R.

    Progressive interventionism will lead to a massive economic collapse – rather than hard times while wages and prices adjust and the economy recovers.

    You make your choice in November.