Regular commenter THR made this comment in the Open Forum
Graduate from the Rush Limbaugh school of Economics, dot is now flat-out lying. Banks had to make those predatory loans, on fear of hypothetical anti-discrimination lawsuits. This sort of explanation belongs in comedy.
It would be funny if it wasn’t actually true.
Here is an op-ed by Paul Craig Roberts in the Washington Times from December 1993 (no link)
A subsidiary of a New England bank has just been extorted out of $1 million dollars by the Justice Department, the Federal Reserve, and the Federal Trade Commission, and everyone is happy about it, including the bank president and the stock analysts who follow the banking company.
Happiest of all will be the unsuspecting recipients of the booty – blacks and Hispanics who were fortunate enough to be turned down for a mortgage loan by Shawmut Mortgage Co., a subsidiary of Shawmut Services Corp., a bank holding company headquartered in Hartford, Conn.
The bank president is happy because in exchange for the $1 million payoff, the Federal Reserve has withdrawn its opposition to Shawmut’s acquisition of the New Dartmouth Bank in Manchester, N.H.
The stock analysts who follow the company are happy because the roadblock to Shawmut’s acquisitions has been removed, and the value of the bank’s stock and the share prices of pending acquisitions have risen in the market.
The Justice Department, the Federal Reserve, and the FTC are happy because they have succeeded in establishing that banks must divert a percentage of their capital into bad loans to minorities in order to avoid regulatory problems with the federal government. As Attorney General Janet Reno stressed: “I am hopeful that the industry will learn from Shawmut’s experience. Do not wait for the Justice Department to come knocking.”
As of yet, no one has identified the individuals who luckily suffered the alleged discrimination. Believe it or not, there were no individual complaints from minorities.
Being in the mortgage business, Shawmut wanted to write as many mortgages as it could. It aggressively sought mortgage business, and gave its loan officers broad discretion to approve loan applications that failed to meet normal guideline requirements. The bank permitted loan officers to fall back on alternative or “compensating” criteria when normal requirements could not be met.
The Justice Department found discrimination in the fact that Shawmut had no internal review mechanism to make sure that each loan officer provided every less-qualified applicant with the identical advice and help in how to substitute “compensating” criteria for bad credit and employment records.
In other words, the bank was a victim of its policy of leaning over backward to grant loans to people who could not meet the normal criteria. If the bank had no such formal policy to help blacks and Hispanics, the Justice Department could not have charged that the bank’s lack of supervision over each loan officer’s interpretation of the alternative criteria constituted discrimination.
The Justice Department brought to court no evidence of a single case of discrimination. What it brought were statistics that the mortgage denial rates for blacks and Hispanics were higher than for whites.
Once upon a time, discrimination required intent; a person could not accidentally or unintentionally discriminate. If one racial group was more economically successful on average than another, it would show up in loan approval rates.
Today, discrimination simply means statistical disparities, and the only way a bank can prove it is not discriminating is to have the same mortgage rejection rate for every racial group regardless of differing economic performance.
In the Shawmut case, there is literally no evidence of what would normally be construed as discrimination. To the contrary, between 1990 and 1992, when the discrimination allegedly occurred, the mortgages granted to minorities doubled and the mortgage rejection rate fell by 45 percent for blacks and by 26 percent for Hispanics.
Now that Shawmut has agreed to pay $1 million or more, victims have to be found so they can be rewarded. The bank and the Justice Department have put together a team to search out 75 to 150 people, who can be said to have been “unfairly” turned down for mortgages. The unsuspecting parties selected by the team will receive between $10,000 and $15,000 each. Of course, no whites are ever unfairly turned down, so no rejected whites will qualify for the lottery.
By agreeing to be extorted, Shawmut has created a new game for qualified minorities: make loan applications to as many lending institutions as possible, and sooner or later a regulator will award you a jackpot.
Those who own bank stocks might want to consider alternative investments.
Okay, you might think that’s an outrageous claim – Lawrence Lindsey, then a member of the Board of Governors of the Federal Reserve System certainly thought so. He wrote a reply. (no link)
The Dec. 20 column by Paul Craig Roberts, “How to rob a bank legally,” was not up to the author’s usual standards. The piece contains at least two factual errors and a number of faulty conclusions.
First, it simply is not true that as a result of Shawmut’s $1 million settlement with the Department of Justice “the Federal Reserve has withdrawn its opposition to Shawmut’s acquisition of the New Dartmouth Bank in Manchester, N.H.” Shawmut is prohibited by law from acquiring New Dartmouth Bank without Federal Reserve Board (FRB) approval, and on Nov. 15, Shawmut failed in its attempt to get that approval. Shawmut still has not obtained that approval. Shawmut failed to receive approval from the FRB for two explicit reasons: the high rate of inaccurate data provided in Shawmut’s Home Mortgage Disclosure Act (HMDA) filing and the inability of Shawmut to show that it had programs in place and working to ensure compliance with the Equal Credit Opportunity Act (ECOA). These showings were particularly important because in December 1992, the board found that there was reason to believe that a pattern or practice of lending discrimination existed at Shawmut.
Resolution of these matters will require an examination of the accuracy of the bank’s HMDA data as well as a reviews of the effectiveness of the program Shawmut has designed to ensure compliance with the ECOA. The board has granted Shawmut until March 1 to seek reconsideration.
The second inaccuracy in Mr. Robert’s piece was the assertion that regulatory agencies, including the Federal Reserve, have established “that banks must divert a percentage of their capital into bad loans to minorities in order to avoid regulatory problems with the federal government.” Far from requiring that bad loans be made, the Federal Reserve’s examination staff would criticize a bank that made a bad loan to anyone, regardless of race. Preservation of a safe and sound banking system is our first responsibility.
The Federal Reserve requires -and indeed the law requires – that the same criteria be used for all applicants. Mr. Roberts claims that banks will get in trouble if they have an informal policy of “leaning over backward to grant loans” to blacks and Hispanics. That is not true. What banks should do is avoid leaning over backward more for white applicants with sub-par credit histories than for similarly situated minority applicants.
Finally, while I cannot speak to the practices of the Department of Justice, the Federal Reserve does not believe that “discrimination simply means statistical disparities” or that “the only way a bank can prove it is not discriminating is to have the same mortgage rejection rate for every racial group regardless of differing economic performance.” Our compliance procedure uses a computer to select white and minority applicants with similar characteristics. If, in spite of the similarity of characteristics, it is frequently the case that the white applicant was approved and the minority applicant rejected, then we strongly suspect that something is amiss. We then follow up with a detailed examination of actual files. Unlike Mr. Roberts’ implication that there are no “victims” of discrimination, this procedure clearly identifies who the victims might be.
Tackling the problem of racial discrimination in lending is crucial because it tears at both our political belief in democracy and our economic belief in capitalism and free markets. Mr. Roberts’ piece did a disservice to those who are trying to find solutions to this difficult problem.
All well and good. But what is Lindsey saying these days?
The regulatory community was placed under intense political pressure to come up with ways of providing access to credit for those populations, and did so, most notably with new rules under the Community Reinvestment Act. I was involved in that process and am proud of what was accomplished. In fact, most of those individuals could be and did turn out to be responsible borrowers and homeowners. But there can also be little doubt that in hindsight the new regulations did contribute to some of the excessive expansion in credit that has occurred. I note this mainly to provide a cautionary tale. Even very well intentioned and largely successful regulations can have unintended consequences. That does not mean that such actions were wrong, but that we should be very careful in how we use legislation and regulation in “solving” current problems.
Now Lindsey isn’t quite unrepentant, but to my mind this is a confession of wrong-doing.
The Marxist shakedown continues:
Under far left scumbag Eric Holder, the financing of left-wing activist groups is now becoming compulsory.
C.L.
7 Aug 10 at 10:35 am
The regulations you cite, Sinclair, were so minor in the causes of the GFC as to be little more than a distraction. There are a number of things for which the above does not account.
Firstly, every other industry has to live with anti-discrimination laws, so the ‘poor downtrodden banks’ shtick doesn’t hold up. Lindsay says above that is was merely necessary for banks to provide the came lending criteria to all applicants, irrespective of skin colour. This is hardly onerous, I would have thought. If the banks were ‘forced’ to lend to financially dissolute blacks and hispanics, this could only have been because they were also doing the same for whites.
Secondly, the above account pretends that there were no incentives for banks to lend, irrespective of regulators. This has been demonstrated false – the banks very actively pursued sub-prime and NINJA loans, for their supposed profitability in the relatively short-term. In the context of a housing bubble and risks that had been on-sold, banks couldn’t really lose. Again, this is a failure of the market, and, if anything, points to a lack of regulation at the root of the problem, not its excess.
Finally, even if we accept your apparent premise, that banks were strong-armed into making bad loans, this will still not explain how it was that investment banks and others spent extraordinary sums of money to purchase these loans, in repackaged form. The CRA was not exactly a secret, so why was it that buyers on the market refused to factor in the possibility of the loans being duds? Why was there an almost mystical presumption that property prices could rise forever?
THR
7 Aug 10 at 2:00 pm
Where’s my apology?
.
7 Aug 10 at 2:39 pm
Where’s my apology?
Yes, that Ben Eltham fellow is probably wondering why you’re yet to retract your nonsense about banks being forced to leverage at 20 to 1.
THR
7 Aug 10 at 2:44 pm
Australian banks are levered 20:1.
They are completely safe. They are not forced to lend to people who are not credit worthy.
Eltham of course recons there is no risk in forcing bans to make unserviceable loans, and when it is done, under the force of law, it can be conveniently renamed “predatory lending”.
This is rank hypocrisy.
Of course you’re lying THR because I never said they were forced to be levered 20:1.
This deserves another apology.
Eltham’s ignorance and your dishonesty is shameful.
What’s hilarious is you give the uneducated, uninformed Eltham a pass but smear me when I’ve been completely honest.
.
7 Aug 10 at 2:55 pm
Your ‘honesty’ amounts to unstinting gallantry on behalf of investment banks. How noble and moving.
This is what you said:
Have these people ever considered why an unsubsidised lending firm with 20x leverage would willingly lend mortgages to those unable to service their loans?
They wouldn’t.
Eltham doesn’t have an argument, he ahs assertions.
http://catallaxyfiles.com/2010/07/31/open-forum-july-31-2010/#comment-83204
Now, I’ve given you quite a number of reasons why lending firms would behave thus, quite irrespective of hypothetical anti-discrimination suits. That you refuse to acknowledge any of these reasons is a testament to your ‘honesty’. It’s basically market fetishism – players in financial markets fucked up, big time, but since admitting this would make a mockery of your ideology, you have to displace the blame, in its entirety, onto regulators and hypothetical vexatious litigants.
You then said:
To NOT have predatoraily lended would have been ILLEGAL.
But this is demonstrably false. It’s so easily refuted that it’s not even worth the 2 minutes of googling it would take to prove it false. There were a number of incentives in place to encourage risky and predatory lending. We’re talking incentives here, not fictitious big sticks wielded by the courts. Do you accept that these incentives were a factor in the GFC?
THR
7 Aug 10 at 3:06 pm
They are completely safe. They are not forced to lend to people who are not credit worthy.
That first line is utter delusion. No bank is ‘completely safe’. A deep recession in Australia could easily cripple the banks, given the massive levels of private debt.
THR
7 Aug 10 at 3:08 pm
“But this is demonstrably false. ”
Then demonstrate it.
.
7 Aug 10 at 3:18 pm
“It’s basically market fetishism – players in financial markets fucked up, big time, but since admitting this would make a mockery of your ideology, you have to displace the blame, in its entirety, onto regulators and hypothetical vexatious litigants.”
You’re a twit.
You said “before you had a nuanced view…” blah blah blah. What I said all along was that banking is obviously risky, and the social equity provisions etc made risk unable to be properly priced. We don’t have that in Australia and our banks are remarkably sound, despite being financed from US commercial paper until 2008.
Now when convenient, you try to change what I actually said in the past, and try to make out I have some fetish I don’t.
What we say around here is free enterprise is optimal, not perfect.
You can’t help laying the boot into something that doesn’t exist though.
.
7 Aug 10 at 3:22 pm
Now when convenient, you try to change what I actually said in the past, and try to make out I have some fetish I don’t.
No, in the past you seemed to have a broader view of the GFC, IIRC, wherein you did put some blame with government, but also acknowledged a range of practices by banks that contributed to the GFC. If I’ve got this brief summary wrong, please feel free to correct it. Now, it seems you’ve re-written the history books to edit out any responsibility on the part of lenders or investment banks. The role of debt-securitisation has been completely revised.
It may arguably be the case that social equity provisions make risk resistant to a supposed ‘proper’ pricing, but this is still a major step back from saying that banks were compelled to issue predatory loans. And if a financial product cannot be properly assessed as to its risk, its still the fault of investors, not regulators, for pouring their cash into opaque financial instruments.
You can’t help laying the boot into something that doesn’t exist though.
Correct, ‘free enterprise’ does not exist. Free market fetishism, on the other hand, does exist.
THR
7 Aug 10 at 3:33 pm
Then demonstrate it.
Have a look at this clip, and then see if you still think the hapless banks/Wall St investors were the victims of regulatory thuggery:
http://therealnews.com/t2/index.php?option=com_content&task=view&id=31&Itemid=7&jumival=3708
THR
7 Aug 10 at 3:37 pm
Economics by you tube.
The GM Bird College is well and truly alive.
.
7 Aug 10 at 3:48 pm
The clip provided a cogent refutation of your ‘the gummint did it’ thesis, by demonstrating the perverse, market-based incentives for risky loans.
THR
7 Aug 10 at 3:58 pm
http://www.iea.org.uk/files/upld-book453.mov
Sinclair Davidson
7 Aug 10 at 4:03 pm
The Northern Atlantic financial meltdown in late 2008 had absolutely nothing to do with Carter’s Community Reinvestment Act or its subsequent minor expansions under Clinton and Bush.
Peter Patton
7 Aug 10 at 4:04 pm
I can’t get the link to work, Sinclair.
THR
7 Aug 10 at 4:25 pm
It’s an IEA book on the crash with a video and audio link.
http://www.iea.org.uk/record.jsp?type=book&ID=453
Sinclair Davidson
7 Aug 10 at 4:37 pm
Peter,
It mostly didn’t, especiallly when you expand it so far. Bad macro conditions dominate everything else. It’s a stretch to call Janet Reno’s threats while in office however immaterial or imaginary to those she threatened as AG.
.
7 Aug 10 at 4:55 pm
Yes, that Ben Eltham fellow is probably wondering why you’re yet to retract your nonsense about banks being forced to leverage at 20 to 1.
US i-banks were levered 35- 40 :1. US commercial banks were around 20-25 :1 while European Banks were around 40 :! and the state owned were 50-60 :1
Fred and Fannie those two amplifiers of American Government virtue were leveraged at 125 : 1.
Free banking would never allow this shit to go on. You seem to think, THR it was the market that caused the banks fail and seem to ignore the fact that the most regulated industry in the western world was leveraged to these absurd levels.
The market would never allow this sort of leverage. In fact governments were promoting high leverage.
JC
7 Aug 10 at 5:24 pm
Dicscrimination or not, it appears that US government support for lending to the poor was the main root cause of the GFC. Of course, many players (banks) have created many other practices that eventually made things worse. But these are natural unintended consequences of bad policy.
Politicians tried to rig the laws of the market. And it did not work. No susprise.
It is not dissimilar to government printing a lot of unsupported money and thinking it can become popular this way.
Boris
7 Aug 10 at 10:15 pm
Dot
While I agree that the country was already on the brink, I blame the unbelievable number of synthetic CDS’ trades which had absolutely nothing physical behind them. While one party held a tranche of a bundle of mortgages, at least they were tied to real actual houses. OTOH, and unlimited number of people could use that same CDO and agree to exchange cash-flows/premiums according to the reference entity.
When it went tits up none of them had any asset backed to their swap, not even a CDO tranche, let alone a house!
The whole scandal should have been regulated by the gaming regulator.
Peter Patton
7 Aug 10 at 10:22 pm
Politicians tried to rig the laws of the market. And it did not work. No susprise.
Really? In what way did politicians try to rig financial markets?
THR
7 Aug 10 at 10:27 pm
Boris
What crap. Subprime mortgages only accounted for 10-15% of US residential mortgages. By the way, before Bush jnr, they never amounted to anymore than 8%!
Peter Patton
7 Aug 10 at 10:32 pm
i reckon synthetic CDS trades made things better. if we didn’t have synthetics then real loans would have been made to even more marginal borrowers and that would have been even worse.
ben
7 Aug 10 at 10:33 pm
No one forced the banks and other lenders to securitise shit loads of loans or embark on risky proprietary trading activities.
You can blame the Fed for dropping the fed funds to 1% and then taking forever to raise them to level even close to neutral.
sdfc
7 Aug 10 at 10:35 pm
Bullshit. The sythetics market was nearly 10 times the size of the ENTIRE residential mortgage market and thus 100 to 150 times bigger than the subprime market.
There was no one else to sell mortgages to.
Peter Patton
7 Aug 10 at 10:37 pm
Really? In what way did politicians try to rig financial markets?
By socialising the risk of billions of dollars of loans.
Michael Sutcliffe
7 Aug 10 at 10:37 pm
Billions, eh? Ooooohhh, how scary. The collapse was of a $100 TRILLION synthetics market.
Peter Patton
7 Aug 10 at 10:40 pm
but the questions was what did the government do? I acknowledge there were private people also doing the wrong thing.
Michael Sutcliffe
7 Aug 10 at 10:42 pm
I am not trying to blame anybody, just understand/explain. Its not that private people did the “wrong” thing, if it was legal.
But from a policy perspective, you had this ginormous offense against double-entry book-keeping. There were only liabilities, and assets.
The reason this was able to snowball was because Clinton (and others) were persuaded that these instruments could be safely left alone as only “sophisticated” investors were involved.
Peter Patton
7 Aug 10 at 10:46 pm
er, NO assets.
Peter Patton
7 Aug 10 at 10:46 pm
Sure. I agree with everything except that something is morally right because it is legal, and I think there are a lot of people who can be identified as holding blame.
Michael Sutcliffe
7 Aug 10 at 10:49 pm
I’m not really sure anybody could have seen any of this coming to accept too much blame. However, if these instruments had been treated like every other – full accounting, etc. the GFC would not have happened, coz the OTC market would have been open to shareholder scrutiny.
Peter Patton
7 Aug 10 at 10:52 pm
I think Fannie and Freddie still represented a time bomb, but I agree that if people could have understood those instruments they would have forced adjustments to be made. I do think people were knowingly using that confusion to hide risk.
Michael Sutcliffe
7 Aug 10 at 10:55 pm
But it would be hard to prove, and unrealistic to get every person who held that blame.
Michael Sutcliffe
7 Aug 10 at 10:56 pm
Well the role of Fannie and Freddie is fascinating. There are basically two prongs.
1. Remember they never sold mortgages themselves. They merely purchased them from those banks and mortgage outfits who did loan money to people to buy houses. Thus, they served as a secondary market. I think at the height of the boom, together they owned about 50% of US residential mortgages.
With the help of IBs they would bundle them up into one security. The IBs would slice and dice that 1 security and sell it on to investors. Freddie take a cut because they agreed to keep the credit risk. It was by these fees that they made money. So while Freddie/Fannie unloaded the market risk of the bundled mortgages, they kept all the credit risk associated with the folks who had bought houses. The opposite was the case for the IBs.
Because adding together 100s or thousands of mortgages reduces the risk substantially of losses associated with any defaults, there was a quid to be made.
So when the housing market did crash, even though Freddie/Fannie might not have had that $5 trillion of mortgages on their balance sheets, they DID have that amount of liabilities through the guarantees they sold.
There were 2 huge flies in the ointment:
1. The IBs and hedge-funds were able to manipulate the ratings agencies into over-rating the bundled mortgages.
2. There was a widespread belief right throughout the market that Fannie/Freddie mortgages came with rock solid government guarantee, which they did not.
Peter Patton
7 Aug 10 at 11:20 pm
“Subprime mortgages only accounted for 10-15% of US residential mortgages. ”
Yes. But the system is unstable. This is enough to cause the snowballing effect.
“There was a widespread belief right throughout the market that Fannie/Freddie mortgages came with rock solid government guarantee, which they did not.”
Again, correct. But the very fact that people, including corporate investors, believed in it, is a reflection of the confusion about government policy. Don’t tell me this belief was totally unfounded.
Boris
8 Aug 10 at 2:56 am
I mean no financial instruments would be ‘toxic’ if it did not, at the end of the chain, involve one bad loan. Therefore it is these 10-15% that were at the root of the problem.
The housing was a bubble. It takes a small needle to burst a bubble.
Boris
8 Aug 10 at 3:01 am
I suggest people read Peter Schweizer’s book, “The Architects of Ruin” first, and then comment.
Peredur
8 Aug 10 at 10:33 am
I suggest you tell us why or run the risk of looking like a pretentious git.
.
8 Aug 10 at 10:52 am
Boris
I mean no financial instruments would be ‘toxic’ if it did not, at the end of the chain, involve one bad loan. Therefore it is these 10-15% that were at the root of the problem. The housing was a bubble. It takes a small needle to burst a bubble.
You are still making the mistake of seeing the GFC in terms of a collapse of the values of actual houses.
Now, there’s a tawdry false dichotomy meme that has tragically infected bthe globe’s talking heads, academics, scribblers, culture warriors of all stripes that the GFC was caused by either:
1. The insistence of successive US presidents to force main street banks , Fannie Mae/Mac, S&L’s, commercial banks, and so on provide more mortgage funds for folks lower down the scale.
And there is no doubt that legislation such as Carter’s Community Reinvestment Act (CRA) (1977). In 1999. Clinton made banks covered by the CRA increase the ratio of these sub-prime loans on their balance sheets (another impetus for CDOs). Finally, in 2007, Bush did some stuff also.
Ultimately, this explanation is bollocks. Not only were the number of mortgages affected a tiiny percentage of CDOs, but it was supply factors that excited folks right along the value chain, not successive politically-motivated Administration fiat.
2.The Evil ‘Neoliberalism’ and its De-regulation
like NINJA loans, which did not require Mr and Mrs Solice to pay a dime 2 years, during which time, they could sell the house, and make a tidy profit in such a booming market. Heaps of folks did flip houses like this, and made a killing. Who wins here, and what does it have to do with synthetic swaps, and the GFC?
But when the music stopped, millions were without chairs. Suddenly, the evil twin of the NINJA-type loans kicked in.
Conclusion: It was the synthetics MBS CDSs wont done it.
Peter Patton
8 Aug 10 at 2:55 pm
“Not only were the number of mortgages affected a tiiny percentage of CDOs”
Bank leverage baby! You only need a small portion of loans to become unserviceable and shit goes awry.
“Suddenly, the evil twin of the NINJA-type loans kicked in.”
Lightly regulated Australia doesn’t have these. We were not unaffected by the financial engineering boom either.
“It was the synthetics MBS CDSs wont done it.”
How?
Anyway.
We need/ed more derivatives and a more liquid market for them.
.
8 Aug 10 at 5:59 pm
Peope are still making the mistake of seeing the GFC in terms of a collapse of the values of actual houses.
Now, there’s a tawdry false dichotomy meme that has tragically infected bthe globe’s talking heads, academics, scribblers, culture warriors of all stripes that the GFC was caused by either:
1. The insistence of successive US presidents to force main street banks , Fannie Mae/Mac, S&L’s, commercial banks, and so on provide more mortgage funds for folks lower down the scale.
2.The Evil ‘Neoliberalism’ and its De-regulation
And there is no doubt that legislation such as Carter’s Community Reinvestment Act (CRA) (1977). In 1999. Clinton made banks covered by the CRA increase the ratio of these sub-prime loans on their balance sheets (another impetus for CDOs). Finally, in 2007, Bush did some stuff also.
Ultimately, this explanation is bollocks. Not only were the number of mortgages affected a tiiny percentage of CDOs, but it was supply factors that excited folks right along the value chain, not successive politically-motivated Administration fiat.
like NINJA loans, which did not require Mr and Mrs Solice to pay a dime 2 years, during which time, they could sell the house, and make a tidy profit in such a booming market. Heaps of folks did flip houses like this, and made a killing. Who wins here, and what does it have to do with synthetic swaps, and the GFC?
But when the music stopped, millions were without chairs. Suddenly, the evil twin of the NINJA-type loans kicked in.
Conclusion: It was the synthetics MBS CDSs wot done it.
Once the physical residential mortgage market was close to saturation – and even before – the whole value chain – at least from the bundlers of debt obligations, especially residential mortgages (but also car loans, commercial property mortgages, college loans) and their customers up (basically IBs, hedge-funds, and their unwitting putative customers, including mutual funds, such as super funds) wanted more and more. So what the geniuses – JPM, GS, etc. – did was essentially set up a shadow mortgage-backed securities market.
At first, I wondered how could they do this, given that all the derivatives and swaps were OTC? Then I noticed that there a few organizations that did keep track of each CDO issue.
Of course, the one player who was able to obtain a great deal more data about these otherwise concealed, behind closed doors, not required to be disclosed on balance sheets, or anywhere in a company’s reports (thank you Bill Clinton. NOT!) was the giant octopus Goldman Sachs.
There is no question that GS has been, and perhaps still, an amazing institutions, with more geniuses than probably all but a few others on earth. It is also blessed with some of the most aggressive, bullying, competitive money-hungry constellations of DNA that ever walked the planet. Killer combo!
Despite the sad ramblings of Krugma, Kwig’n etc. the theoreticxal foundations and empirical identification of the EMH are still robust (more so in its weak and semi-strong forms). However from the early noughties on, the pricing of derivative products became increasingly uninformed. Why?
Because the explosion in these securitized mortages, and the flogging of tranches of CDOs was all done away from not only open exchanges, such as the trading floor of the Chicago Board of Trade, Eurex, the Korea Exchange, LIFFE, Hong Kong Exchanges and Clearing, the ASX, and so on, where not only is every trade and its price instantaneously displayed electronically, for all to see, but the exchanges act as a clearing-house for the trade, thus guarantee full performance of the trade, should things go tits-up for one of the parties. Further, the net positions of individual traders, banks, IBs, hedge-funds etc. are marked-to-market daily, with margin calls from the exchange promptly demanded if things start going too far south.
Role of governments
1. Explosion in state-mandated/encouraged super contributions, 401(k)s, and so on, with most of the monthly contributions going to a mutual fund, super/pension fund, who subsequently had billions of dollars in cash, which they had to invest somewhere to make sure they got annual returns with a decent spread above Treasuries to keep the punters happy, and not choofing off to some other mutual.
2. Traditional futures and options markets for primary products – pork bellies, ornage juice, wheat, wool – and minerals/energy – oil, gold,
3. There were three major pushes to regulate OTC trades, both during the Clinton adminstrations in 1994 and 1998, and 2000, which were rebuffed both times by Clinton. He “came out” and said he made a mistake in 2000.
4. But the very interesting Fannie Mae/Mac stat that gets little or no airplay, is that as of May, 2010, Asian investors, funds, banks, blah still hold $800 BILLION in securities issued by Fannie and Maccaie mainly Japan and China; another $100 BILLION in Europe/UK; another $75 BILLION in Russia; and another undisclosed fortune with mddle eastern sovereign funds.
5. The Greenspan put – artificially low interests to satisfy political needs following the tech-wreck created a mad scramble not only for yield, but capital investment opportunities. Step up the ginormous virgin of US residential mortgages, whose securitization hymen was still in tact.
Residential mortgages had considerably higher coupons than bonds, but most uniquely the quality that most set off the scramble. They were backed by assets long thought to be ‘safe as houses.’
Anyways, they set up these swaps, but not based on any physical tranche they had invested in, based on a real CDO, made up of real people’s real mortgages. Rather, these new swaps were based on a real CDO that some IB did bundle up, and investors who do hold those physical bonds on their balance sheets, known as reference entities. These new-style mortgage-backed credit default swaps were based on the ups and downs of SOMEBODY ELSE’S tranches of CDOs were thus known as synthetics.
Theoretically, presumably 120 different synthetic mortgaged-backed credit default swaps could all be traded with the same single physical CDO, being the ‘reference entity’ for all 120.
Now, given that the protection seller – of not only those trading CDS in the physical CDO market, but also the other 120 synthetic deals – must pay the buyer the full par value of the underlying, should a “credit event” be triggered, that means that 121 investors would have to pony up the full par value of the ONE CDO that defaulted or invoked a “credit event.”
That would mean that when Obama mandated the FHFA to assume ‘custodianship’ of Fannie Mae in 2008, this would fit the definition of a “credit event” on not only every single mortgage-backed CDO that Fannie Mae had bundled up, and sold off in tranches, and subsequently ‘swapped’ by innumerable ‘sophisticated investors.’ No doubt heaps of these swaps were for ordinary legitimate reasons. Thus, every single long position in the swap would have to pay the shorter, the entire par value.
But at least the shorter had actually purchased the physical CDO tranche in the first place, and so the long-guy would get this asset (even though – at least for now – it was worth shit, but might regain its value, and probably would, IF he had enough funds to see him through that long. In this case, the US federal gov’t DID NOT have the funds, but knew where to get it –selling more US-government bonds, and er, er, putting 456,098,344,776,476 trees worth of paper into this li’l here printing press, fill it with another fuel to print for ever, push the pedal to the mettle, and how presto, GFC gone.
But what did they do with all these greenbacks? Well, they bought a tonne of the CDOs stuffed with fraudulent swathes of toxic, fraudulently, rated way above its risk. Through the Federal Reserve Banks, the cash was wheelbarrowed over to the Fed.
BUT what about all those synthetic mortgage-backed CDS’?
The terms of these swap contracts were the same as those on the physical market. Thus, the same “credit event” affected the 120 synthetic trades (assumed in the example above). All 120 of those who were long on the swap, had to pony up the ENTIRE par value!!! As the swaps were only ever made wrt the ‘reference entity’ the shorter never had to actually shell out the dough to buy the physical asset in the first place.
So when Fannie Mae went tits up, 120 shorters – a la Paulson and the likes of Magnetra – received (or at least were entitled to receive from the long party) the FULL par value, just as the 1 guy in the paragraph above had. This is no different that playing Black Jack at a casino, and more likely, playing the pokeys at the local RSL.
So one these ‘credit events’ – and over the past few years, the definition of said events became increasingly generous – became more and more frequent – system-wide, there was only ever ONE physical tranche of the much larger Fannie Mae (for example) originated CDO.
This meant that 121 guys in the system had to lose the entire par value, while only ONE guy out of that 121 gets the original asset in exchange. Ergo, 121 guys RECEIVE the full par value, while only ONE guy out of that 121 had to transfer (swap) the real actual physical CDO tranche, as he was the only 1 out of the 121, who ever bought one!.
This means that system wide, a huge number of folks are suddenly – and immediately – liable for billions, with not once cent of asset, except the measly premiums they had been receiving from the shorter over perhaps only 12 months or so.
With such a GINORMOUS sudden demand to pay the par value of all these long positions on synthetics shadows of non-existent assets trade, it was as inevitable that the holders of these these long positions were going to quickly becomes entwined thus escalating those guys liability. So, Lehman Brothers, you are the weakest link. Goodbye.
All those with short positions on the other side of the swap with AIG, for example, were obliged to pay AIG a monthly/quarterly premium (valued as a spread against the original price when the swap trade was made).
In other words just like you insure your car by paying a small premium to the insurance company either every month until you decide to get rid of that car OR you prang it.
Now, the insurance company gets all this liquid cash every month, and theoretically it gets it for nothing. But of course, the insurance company doesn’t get free money, because ‘chances’ are you will prang your car (perhaps many times) before you get rid of it and buy a new one. Theoretically, judiciously chosen and professionally risk-rated bundled up securities, especially housing-backed mortgages, should be just as safe for the insurance companies – like AIG – as insuring the physical houses themselves. Whenever, somebody defaulted on their housing mortgage, the insurance company would just take possession of the house, and sell it on. Depending on the housing market at that time, It might take a small hit, or make a huge profit.
But AIG wasn’t going long actual houses or the mortgages being paid by Mr. am Ms Flyover State. They weren’t even buying chunks of hundreds or thousands of those mortgages all bundled up, securitized, and divided into slices (tranches). They were buying nothing but the right to receive the exact small premiums that folks in the real CDO markets were paying to the shorters.
But wait, the shorters in the physical CDO market have actually bought a physical bond/tranche, which it can sell or give to the guy who is long. But the guy who is short is owed the fulkl par value, which had been determined at the time the swap was first entered into when the mortgage market was hot, and thus so were MBS CDOs, CDS, and even the synthetics.
So, this long guy receives his due physical tranche/bond from the guy short on the other side of the swap. But hey, guess what? That tranche/bond is only worth 60% of its par value, or in the case of the Goldman Sachs/Paulson Abacus swaps, a whopping TWO percent of the par value. In other words, the long has just lost 98% of what he paid for the physical/tranche.
But what about these guys who built synthetics and swapped them with reference to some physical CDO, for example, say the GS Abacus CDO above? Theoretically, as per the example above, there might be 120 additional swap deals out there all referenced to this ONE Abacus bundle.
AIG was going long on these synthetic CDOs and thus making a killing in the good times, because it received all those premiums, and never had to pony up for CDO issues that went tits-up, because the US housing market was so strong. Now, it seems these guys, these insurance salespeople – usually stuffed with actuaries, hardly Gordon Gecko types – either simply did not realize their MB-CDS involved neither a physical tranche of a CDO, nor a physical mortgage, nor a physical house. How could they not know this!!!???
The only other explanation is that they had such confidence in the AA-AAA ratings that Moody/S&P/blah were giving the bundled mortgages (CDOs), so thought their swap positions were safe as houses.
If this was AIG thinking, there is nothing suss about that. After all, the entire bond market has relied on ratings from folks at Moody’s and other for yonks.
In other words, AIG thought that if things went tits up, it would have to pay out the agreed par value for which the CDO was insured BUT, in return AIG would receive either the physical bonds/tranched and/or the actual real mortgages of real houses, which it could hand on to, and perhaps in a few years make a killing. But the computer said no, because AIG received three-fucks of fuck all, but had to pay every single hedge-fund, mutual fund, investor who was short the swap the FULL par value of the GS Abacus-derived cash-flow at the original par value.
The centre cannot hold. Things Fall Apart.
How did this happen? One way was that many of the physical bundles of real mortgages, increasingly had really bad shit stuffed into them, which were not reflected in a lower credit rating for the CDO over all. But who did this “stuffing?” The popular press has been haranguing GS, and the like.
Thing is, GS was mostly a middle-man, a broker, who received a fee/commission for arranging the CDO, for some investor or t’other. Thus, when GS and the IBs were acting in this capacity, it was no different that when they organize an equity raising or bond issue for General Motors; but instead of equity shares or bonds in a car company, investors were buying a slice of bundled up residential housing mortgages, from which they would receive quarterly cash payments via Mr. and Mrs Flyover paying their monthly housing mortgage.
GS raises the finance, its boffins do all the structuring, GS underwrites the issue (and probably gets a few other IBs as co or subsidiary underwriters to spread the risk), then they hit the phones and the private jets to sell the entire CDO bundle.
There are two remaining suspects:
1. The rating agencies were off their tits when they did the math on the putative bundle of eleventy-four mortgages that made up the CDO that GS et al, would then sell. OR, they were negligent in doing so.
My theory is this:
The ratings agencies, increasingly from the early noughties, knew damn well the CDOs they were rating were increasingly stuffed with junk – mortgages taken out by unemployed Latinos, who has been swindled by unscrupulous mortgage-brokers that they had really neat mortgage products.
But why were these poor people with bad credit, and sometimes no job, let alone a brass razoo for a deposit on a house, even if was in Detroit!
A: The mortgage-brokers could be so pushy, because once the IBs had cottoned-on that residential mortgages was one ginormous market whose securitization potential has been ignored, within months their boffins had perfected the CDOs, and with their huge and octopus-like distribution channels, they could get rid of them, without Mr and Mrs Solice’s hacienda in suburban Houston, ever darkening the IBs balance sheets.
Thus the mortgage brokers (who make their living from commissions on house sales) started getting pressure from the mortgage-writers – high street banks, credit unions, etc. to turn up the heat and get them more mortgages, because Wells Fargo, Citibank, etc. now had a never-ending seamless pipeline to the Fannie Mae, Fannie Mac, and the IBs, who couldn’t get enough of these mortgages to bundle, and on-sell to their clients (particularly clients who like cash flow, rather than capital growth), who would hold them as high-yielding bonds: pension funds, mutual funds, super funds, and the whole array of folks who invest in stuff, basically, not only in the US, but across the entire globe.
Basically, for nearly a decade hald the globe’s CO2 emmissions came from private jets filled with 28 year old fixed income and derivatives salespeople from JP Morgan and Goldman Sachs lapping the globe dropping tones of these ticking securities of mass destruction on to suckers from the Greek government to Edinburgh.
So far, we have no synthetics being put together, and traded. So where is the ticking bomb at this stage?
A: The lowly mortgage-broker. Huh? As the mortgage underwriters – folks once step up from the mortgage-broker in the CDO food chain – became under pressure from folks further up the chain – JPM, GS, who themselves were coming under pressure, not only their typical clients – the mutual funds – but incxreasingly hedge funds, whose private ownership gave them even disclosure exemptions, and opportunities for secret plots, ploys, and trades.
What’s this got to do with mortgage broker?
Basically, from the mid-90s on, they were given the green light to lend even further down market.
Policy implication: (From a non accountant). Every liability – present, future, potential – must be matched by a REAL asset SOMEWHERE in the global income statement.
My Own Political Stance (MOPS): The creators and players of synthetic CDS have gone so far beyond what is acceptable, even within my own somewhat libertarian/laissez faire commercial ethics, these bankers and hedge-fund managers MUST pay with money (their own, not just the shareholders) and their liberty. Their bonuses and assets must be clawed-back, even if a constitutional amendment is necessary.
Wall Street and banking in general are far, far, far too important to liberal societies. The loss of confidence and trust among hoi polloi is more than just their chutzpah.
String the bastards up, and let us celebrate as they swing!
And my god, don’t we ADORE the Magnetar Trade? Buy the shitty equity tranches of CDO to keep the CDO market afloat, use the subsequent cash to short the same CDO through a CD SWAP, collection the whole par value when the CDO inevitably goes tits up.
As a result lots of IBs and hedge funds simply stuffed really shitty mortgages into the bundle, which none of the investors knew about. Why didn’t the investors do what I would do instinctively, and run a ruler over every single mortgage, even if only getting an analyst to check the spreadsheet? Not enough time? Trusted the IBs/hedgefunds, and rating agencies?
Fund managers, etc. should be sued, impoverished, jailed, hung, drawn, and quartered as well, for being too DUMB to understand the products, and doing the appropriate ethical and prudent, and fund member interests by steering clear of that of which they were ignorant. To the gallows!
Fucking fools if that was the case. They deserve to be poor
Conclusion: It was the synthetics MBS CDSs wot done it.
Peter Patton
8 Aug 10 at 6:17 pm
synthetic MBSs just help price discovery + transfer wealth between different people. they can’t be responsible for a massive decrease in real wealth unless there is something else screwed up. if we didn’t have synthetics it would have been worse because even more marginal real investments would have been made in order to satisfy demand.
synthetics are great in a bubble because they allow investors who believe massive malinvestment is going on to convert that malinvest from the real economy to the transfer economy.
blaming synthetics is the very typical human behaviour of piling on the contrarians when they turn out to be correct. better to be wrong and with the crowd than correct and a pariah.
the real problem was probably tight money by the fed and other central banks when the monetary supply collapsed.
ben
9 Aug 10 at 12:58 am
No one forced the banks and other lenders to securitise shit loads of loans or embark on risky proprietary trading activities.
Not true. The SEC, The Fed, Basle 2 all contributed to the love of securitization, not that there was anything wrong with the practice. At the end of the S&L crisis the SEC and the rest of the gang pushed banks to securitize everything that could walk based on the belief that a security could be easier to peddle in the event of a liquidity problem. The decision was made to treat securitized debt with a much smaller capital requirement than an ordinary loan.
So you’re wrong. Period. The banks were certainly induced to securitize.
You can blame the Fed for dropping the fed funds to 1% and then taking forever to raise them to level even close to neutral.
Easy to say but hard to find credible. The tech crash produced a very real possibility of deflation and the markets were spooked at the possibility. The Fed’s action was an attempt to prevent that from happening.
There are good arguments in place that the Fed went to tight in 06 to 07/08.
SDFC, you don’t know what you’re talking about.
JC
9 Aug 10 at 1:12 am
At the end of the S&L crisis the SEC and the rest of the gang pushed banks to securitize everything that could walk based on the belief that a security could be easier to peddle in the event of a liquidity problem. The decision was made to treat securitized debt with a much smaller capital requirement than an ordinary loan.
So you’re wrong. Period. The banks were certainly induced to securitize.
Oh cmon.
You make it sound like the SEC forced lower capital requirements on banks.
Bullshit.
Every time capital requirements have been lowered it’s been following heavy bank lobbying.
Banks love lower capital requirements.
The SEC doesn’t force it on them.
Anyway, I’m pretty sure that it was the Office of Thrift Supervision and not the SEC that set capital requirements for S&Ls. Could be wrong.
Tillman
14 Aug 10 at 12:22 am
You make it sound like the SEC forced lower capital requirements on banks.
Bullshit.
They did and Basle 1 or 2 followed. Don’t believe me? Check out what the the capital haircut required for a straight unsaleable industrial loan vs a security of the same pedigree.
The reason they did it was that they believed liquidity enhancement created through secularization would offer banks a more stable environment after coming out of the SL crisis.
It wasn’t bank lobbying either. The SEC chairman, Artur Levitt was the main dude forcing it at the time.
JC
14 Aug 10 at 12:56 am