Present at the creation, of the 2008 financial crises
October 6th, 2008
Seth J. Frantzman
From 2002 to 2004 I was a drug pusher. Not the illicit kind like cocaine and meth. I pushed the legal kind, mortgages, a drug that is no less addictive. I began as a telemarketer, convincing people to refinance their homes, and graduated to processing those loans and finally selling borrowers loans to buy homes. Along the way I obtained a real estate license and was exposed to that side of the business as well. I was a minor cog in a large organism, a great industry which helped people purchase homes and take equity out of those homes. Today the world’s financial markets are in crises because of these type of activities. For two years I worked in one of the hottest real estate markets in the United States, in Tucson Arizona.
Now the politicians are blaming everyone but themselves for the financial crises. They have lashed out at the ‘fat cats’ and the ‘speculators’. On October 6th disgraced Lehman Brothers CEO Richard Fuld testified before congress about the financial crises, which is now being blamed, partly on the failure of his firm, which filed for Chapter 11 on September 15th, 2008.
In September of 2007 I had an argument with my father about whether or not the dream of every American to own a home is a positive part of the American ethos. I felt at the time, as I still do, that there is nothing more essential to the American tradition than the personal responsibility derived from the ownership of one’s own land. This was an ethos that Thomas Jefferson articulated when he described an Agrarian American nation, who he idealized as a nation of smallholders. Farmers were the “chosen people” of God, a term he used in his Notes on the State of Virginia, published in 1781. Jefferson noted that “those who labor in the earth are the chosen people of God, if ever he had a chosen people, whose breasts he has made his peculiar deposit for substantial and genuine virtue. [In contrast] Dependence begets subservience and venality, suffocates the germ of virtue, and prepares fit tools for the designs of ambition.” Home ownership was ingrained in the tradition even in the earliest days of the American frontier when people escaped the claustrophobia of the east coast to search for their own plots of land. The movement of Americans away from the east coast and towards home ownership has continued to this day and has peaked in places such as Tucson and Prescott Arizona, where rapidly growing cities have opened up formerly dead land to home ownership through the creation of new sub-divisions.
But along the way something happened. Jefferson’s ideal of the personally responsible small holder gave way to the credit addicted home owner of the 1990s and 2000s. By the time that I took a job at Allied Home Mortgage people were taking on 105% loan to value mortgages in order to get into their homes. These mortgages, which sometimes included second and third mortgages as well as seller carry backs covered the closing costs of the borrower so that he was actually paid to get into his new home. These closing costs could be quite substantial and were part of the elaborate system whereby purchasing a home becomes a sort of trough for pigs to feast on. With the endless mantra that “homes appreciate at 12% a year” the borrower was not only encouraged to take on a huge loan-to-value but also to refinance his home as soon as rates dropped. Sometimes people were refinancing two or three times in a ten year period, and this in a state where the average person sold their home every five years. The Jefferson fantasy of a nation of farmers owning their own land certainly could not have included a nation of people living on credit and selling their homes every 5 years, homes whose debt they hadn’t paid down more than a few percent by the time they sold them and due to refinancing probably owed more than they had originally purchased them for. But nevertheless these borrowers were addicted to the drug of ‘equity’. Even if they weren’t saddled with two or three mortgages on the same home and they weren’t refinancing they were taking out ‘home equity loans’, using the home “like a credit card” but one in which the “you only pay 5% interest on.”
Recent revelations show that AIG sold billions of dollars in Credit Default Swaps, a sort of insurance that allowed banks to collect if the loans they guaranteed went bad, out of a London business unit, putting themselves in the hock for more billions in payouts when loans went bad. This shows how the mortgage crises spread like a virus beyond the banking industry. Other revelations show that Daniel Mudd, the CEO of Fannie Mae, was encouraged by Congress and by his own instincts to take on ever more risky loans, providing more and more liquidity to the market to sell more and more loans for which there was little collateral. During his questioning by Congress, Lehman CEO Fuld was accused of being a ‘thief’ for having bundled mortgages that were originated at values above those of the homes they were tied to and thus helped create a mess when those borrowers defaulted. Fuld correctly noted “I don’t know why anyone would knowingly originate a mortgage for more than the value of the home.” But what the questioning revealed was how little congress understands how the mortgage industry works. The very fact that a U.S congressman thought that the CEO of Lehman Brothers was responsible for the fact that loans were given for homes where the value was below the amount of the loan goes to show how removed congressmen must be from the entire industry.
So let’s recall exactly how the system actually works. The process begins with a person who wants to buy a home. He locates a realtor. The realtor tells him that investing in a home is better than renting because the home will appreciate at 12% a year and that mortgage payments are about the same as renting, meaning you make money every year rather than “flushing it down the drain.” The buyer finds a home and makes an offer. The realtor usually runs ‘comps’ for the home before the offer is made. This print out compares other homes that are similar that have recently sold and shows the average price per square foot. This supposedly tells the buyer whether he is making a sound decision. In reality in a wild real estate market where realtors charge 7% commissions this helps to cause the price of homes to rise a minimum of 7% everytime they are sold (because the seller must cover the costs of the realtor), the cost of the home does not always reflect its ‘value’. So the buyer makes an offer and it is accepted by the seller. It is not in the realtors best interest to delay the sale so he works with the listing agent, or sometimes as the only agent on the purchase to facilitate a quick sale. But the buyer must be approved for a mortgage. Sometimes he has been ‘pre-approved’ for a loan. In this case he has already been guided to a mortgage banker. He might be a very sound borrower. In this case the loan he will receive cannot have monthly payments (principle, interest, taxes and insurance payments are bundled together into one monthly payment) that exceed around 35% of his monthly income. But increasingly between 2002 and 2007 borrowers were invited to get involved in more and more exotic products. Sometimes they were encouraged to be involve in ‘interest only’ loans where they only pay interest in the hopes that the house will appreciate so much there is no reason to pay down the principle. Sometimes they chose an ‘Option ARM’ or adjustable rate mortgage where they could choose to pay interest only or principle and interest or payoff the loan in 15 rather than 30 years. Some of these loans adjusted after three or five years, but some even more exotic products allowed the bank to actually increase the principle if the loan adjusted and the borrower only paid the interest. Some of the loans, especially those going to less than perfect credit borrowers included ‘pre-payment penalties’ so that the borrower, who already has bad credit, was given a high interest rate, some 2-5% above the regular one, and then not allowed to pay off the loan in less than five years or so or incur a penalty. In this case the bank thought it was locking in this higher interest rate for these years, but in actuality the bad credit borrower was now forced to pay more and the risk f default increased exponentially. From the bank’s point of view this made sense since the borrower was a higher risk. The borrower could also choose, sometimes, from ‘low doc’ or ‘no doc’ loans and ‘stated income’ loans. In these cases, usually if the borrower had decent credit, he was trusted to state his income (rather than supply tax returns, bank statements and pay stubs) and accept a slightly higher rate for this privilege. Truly risky borrowers were saddled with multiple loans. One bank would provide a loan for some 90% of the value of the home, protecting itself against the higher chance of default by the untrustworthy borrower. Then a second lender would cover another 7% of the value of the home for a higher interest rate, taking on more risk in exchange for more interest. Then a third loan might be tacked on, perhaps by the home seller, as a form of ‘carry back’ loan for another 5%, covering the closing costs of the borrower so that he would actually get some cash back at closing,. But this third loan might be at 12% interest or some outrageous figure. Saddled with three loans for some 102% of the value of the home the bad credit borrower now had an incentive to make his credit worse by defaulting on all three loans. But no matter, he was assured by the realtor that the home would appreciate by 12% in the first year. So for a $100,000 home, although he owed $102,000, it would be worth $112,000 after the first year. When he couldn’t make his payments he could always sell the home, paying the same realtor 7% or $8,500, meaning that he would receive a profit of $1,500 after the first year, having invested not one cent.
My former employer, Washington Mutual, ran itself to the brink of Bankruptcy because of its wild mortgage ways. Allied Home Mortgage, another employer, was sued by countless borrowers who felt they were fleeced in their refinancing. They were told they were lowering their payments, which was true, but they didn’t realize that they were losing thousands of dollars in equity through refinancing.
In this crises one cannot ignore the role of all the other people who benefited from the mortgage binge. Appraisers were at the trough as well. In the cases where houses turned out to be worth less than their perceived values it seems the appraisers were encouraged to stretch their values and underwriters and loan processors never caught on or were in ot it because they too got paid for each loan originated. When Congress claimed that investment banks like Lehman brothers ‘stole’ from Americans by reselling these mortgages they seemed to have missed this entire industry of appraising. There were also ‘home inspectors’ at the trough. This group of people is probably the largest part of the home purchasing scam. They write large reports about the home, claiming to have ‘inspected it’ but they admit they are not experts in plumbing, structural integrity or wiring and that should the buyer truly want to check any of the things in the ‘home inspection’ that they should hire a professional. This is a point realtors also stress. They aren’t responsible in any way for telling how much a home is worth or how much it will appreciate because they are not professionals, but this doesn’t bar them from telling borrowers all sorts of thing. One must not forget that the title company, home warranty seller, termite inspector and numerous other people are at the trough before the home purchase is closed. Literally thousands of dollars are churned out of each home purchase, some from the borrower and some from the seller. When its all over the value of the home is not only increased 7% to cover the realtor fees but also another 3-5% to cover the costs of the mortgage and the other people involved. No wonder homes ‘appreciate’ at 12% a year. That represents precisely the percent of the value of the home that goes into the trough during a closing.
A lot of people got fat during the housing bubble. It wasn’t just Lehman executives. Congress wants a quick fix and an easy scapegoat. But from the highest pashas in Congress who should have pushed better oversight of Fannie and Freddie, down to the borrowers who defaulted, many people were to blame. It wasn’t merely the American dream of home ownership that has been harmed. It is an entire way of life that was built on credit. This is a recent phenomenon. While it may appear that numerous Americans have ‘fulfilled’ the dream of home ownership, the fact that so few of them have paid their homes down means that America may be farther from the Jeffersonian dream today than it ever has been. All the drugs that Fannie Mae peddled over the years, including the scams known as FHA loans and HUD homes and ‘Affordable Housing’ or the scam called ‘ACORN’ provided millions of people with homes who never worked for them and never intended to work to pay them off. The idea that “low income” borrowers deserved to have all the mortgage rules bended for them so that they ended up with monthly payments that equaled some 65% of their monthly income was a recipe for default. And yet, in the name of good intentions, billions of dollars was pumped into the mortgage industry so that ‘low income’ borrowers could have these ‘affordable’ loans.
Only when the addiction to credit is cured can Americans get back to the business of living the Jeffersonian ideal.
The Other invisible hand
Seth J. Frantzman
September 25th, 2008
Adam Smith spoke of the invisible hand which guides the markets. This shows itself in economics and capitalism. It also shows itself in the idea of market efficiency. The hidden hand is the opposite of the government hand, it is supposed to make markets work better without the need for socialism and nationalization. But now, with the U.S economy in crises, the government has been on a binge of regulatory and governmental fixes. First there was the government intervention to help the sale of Bear Stearns to JP Morgan. Then there was the nationalization of Fannie Mae and Freddie Mac which were Government Sponsored Entities in the first place. But the decision by the federal government to intervene in the collapse of AIG was truly 'un-American' in the words of Senator Jim Bunning, Republican of Kentucky. The government has also stepped up other unorthodox strategies, including forbidding short selling of some financial securities and also considering regulating the pay executives receive, if those executives intend for their companies to take part in the bailout. As it stands today, September 25th, the Treasury Secretary, in collaboration with the chairman of the Federal Reserve, is seeking some $700 billion to save the U.S economy from disaster. Bush reiterated this when he said "our entire economy is in danger." Specialists claim it is the worst disaster since the great crash of 1929 or the crises of 1907. Of course, we won't know until its over.
On September 24th, 2008 world leaders addressed the United Nations general assembly in new York. Several of hem blamed 'speculators' for the financial mess. President Abdoulaye Wade of Senegal noted that "we are once again the victims of speculation. This speculation puts the developed world in danger." President Luiz Inacio Lula da Silva of brazil claimed that speculators were causing the "anguish of entire peoples." Evo Morales of Peru went further and claimed that the "capitalist system is the worst enemy of humanity." It is interesting, and predictable, how soon after a financial crises develops that the hidden hand of the 'speculator' will be blamed. The speculator, the dark hook-nosed, secretive, greedy, hunch-backed, thing that lurks around Wall Street and ruins financial markets. It goes by other names as well. Sometimes it is the 'fat cats' that are to blame. What is surprising is the degree to which intelligent humans, those who are responsible for running whole countries and thus, in theory should understand financial and economic systems, are so easily convinced to blame some secretive cabal of 'speculators' for a massive crises. It points to the human need, in democracy and dictatorship, to blame something for the problems, because people have a hard time ascribing blame to themselves or to things that actually deserve to be blamed.
It would be too hard for a world leader to see that the housing crises has been a slippery slope that began with some predatory mortgages and housing price shortfalls, resulting in the non-payment of mortgages, which resulted in the collapse or near collapse of sub-prime mortgage lenders in the U.S and U.K and that this led to further harm coming to regular mortgages, many of which were held by Fannie Mae and Freddie Mac. This led to the loss of money by investment banks such as Bear Stearns and Lehman Brothers who had bet the wrong way on numerous financial instruments. At the same time a crises in the credit markets, rising inflation, the extreme rise in oil prices (from $30 to $150 over a year period) led to the seizing up of the credit markets and meant that there was less money for firms such as Bear and Lehman went they went back to the trough to re-capitalize themselves. Their declining stock prices made them seem unstable and they were sold or collapsed. Meanwhile AIG, which had held huge positions in Credit Default Swaps and other financial insurance securities that had never been completely tested in a crises found itself on the wrong end of insuring the wrong thing. But AIG was 'to big to fail' since its failure would spread to other things, so the government stepped in to prevent its collapse and now the government demands to be given the right to inject a massive amount of capital into the market to shore up the bad mortgages, helping to free up credit and insure that these 'toxic' assets held by so many firms will be backed by the power of the U.S treasury, allowing banks to go back to business as usual.
This complicated explanation couldn't be true. We must use Occams razor and see that the simplest explanation is the best. It is the speculator that is to blame. This shadowy figure is the one that drives the stock prices down and he collaborates with the 'short seller' who makes money as the stock collapses and together they suck the blood of the American tax payer. Yes. This is obvious. It’s the corporate fat cat and his huge salary that is to blame. But Humans and world leaders need some\thing simple to blame. Because of this they need the scapegoat, the other 'invisible hand' that is behind their economic problems. The Soviets blamed the 'wreckers' and 'parasites' who 'did no work'. Hitler had the Jews. Everyone needs someone. Or maybe its some other amorphous thing that’s to blame, such as 'globalization' and the WTO and the 'World Bank.' It must be.
It couldn't be John Mitchel and Ann Sawyer and their sub-prime mortgage in Mesa Arizona and their non-payment of that mortgage that has steamrolled, along with a million other people behind on their payments to cause this hiccup in the financial markets. It couldn't be complicated and misunderstood things such as Credit Default Swaps (CDS) which Warren Buffet described as hazardous because: "unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses -often huge in amount- in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)." Simply put, CDS can amplify risks in the end, even though they seem to have insured against defaults. Too complicated. Its easier to blame the 'speculator'.
Is the world economy collapsing?
June 24th, 2008
Seth J. Frantzman
Record high oil prices. Housing crises. Bank crises. Credit crises. Declining dollar. Food crises. Inflation. All these economic woes have caused a great deal of alarmist rhetoric. The people who were once talking about 'Dow 50,000' are now speaking of the doomsday. The most important question is: will there be an economic collapse because of the intersection of so many economy-killing indicators? One important thing to keep in mind is historical economic declines and their relationship to similar events in the past.
In 1972 the price of a barrel of oil was $2 a barrel. Because of the Yom Kippur 1971 Arab-Israeli war an OPEC oil embargo was inaugurated against specific western powers, raising that price to $3.65 by October of 1973. By 1974 it was $12 a barrel. The price of a gallon of gas rose from 28 to 55 cents in the same period in the U.S. U.S imports of oil from Arab countries decreased from 1.2 million barrels a day to 19,000. Daily oil consumption dropped by 7%. This crises was followed with a further crises in 1979 due to the Iranian revolution when striking oil workers and the expulsion of foreigners from Iran caused the price of a gallon in the U.S to rise from $15 to $39 a gallon. During the 1980s, by contrast, the price of oil declined, with the price of a barrel declining by half. By 2000 the price of a barrel was around $25 and by 2007 the price of a barrel had reached $60 a barrel. By the end of May of 2008 it was $120 a barrel.
In 1948 and 1951 Inflation in the U.S reached 9% briefly. But for most of the 1950s and 1960s it was under 4%. In February of 1973 it began to climb. By February of 1974 it was at 10%. In December of 1974 it reached a high of 12% before declining and hovering at 5%. (http://www.miseryindex.us/irbymonth.asp) In April of 1974 it began a climb once again. In January of 1980 it was at 13% and reached an all time high of 14.76% two months later. During the Reagan years it began a long decline and hovered between 1 and 5%. It continued to remain steady, reaching 6% under Bush Sr. before declining under Clinton and remaining firmly 1-4% range. In October of 2006 it reached a low of 1.31%. In May of 2008 it was at 4.18%.
The American dollar has also been declining, reaching lows against the Euro, the Yen, the Sheckel and the Canadian dollar. US News and World Report diagnoses five reasons for this: slow growth, federal reserve outlook, credit contagion, trade gap and currency diversification (countries diversifying their holdings out of dollars and into Euros or other currencies).
In May of 2000 the exchange rate was 1.5 Canadian to the U.S dollar. In May of 2008 it was 1.01 to the U.S dollar. In June of 2008 it was $1.9 dollars to one English Pound. By contrast in 1949 it was $4 to the Pound (the same year the pound was devalued to $2.80). In 1976 the value of the Pound fell to a low of $1.57 and at its lowest point in 1985 it was $1.05 to the Pound. It was $1.5 in June of 2000. In June of 2008 it was $1.5 dollars to the Euro. It was $.93 in June of 2000. One received 105 Yen to the dollar in June of 2008 and in June of 2000 it was 108 Yen to the dollar. In April of 2002 it had been 130 Yen to the dollar.
In the 1980s a number of small local banks or thrifts, known as Savings and Loans, collapsed causing some $160 billion in losses. Part of the reason for the collapse was an extension of more and more credit to home buyers, which had totaled from $700 billion in 1976, totaled $1.2 trillion in 1980. The extension of too much credit to home buyers, combined with bad loans, chicanery, short term inflation scares and other factors resulted in a series of bank failures. This caused a 'Savings and Loan Crises' that stretched into the 1990s and saw 1930s style 'runs' on banks, with people lining up to get their money out, fearing that they lacked federal protection (FDIC insurance) against their losses. In fact the number of federally insured S&L banks declined from more than 3,000 to 1,600. The market share of mortgages originated and held by them also declined from 53% to 30%. In response to the crises the government created an 'Office of Thrift Supervision' to supervise savings institutions. The recent 'Subprime mortgage crises' has some hallmarks in common with the S & L crises. Both involved a housing boom and the extension of mammoths amount of credit to home buyers. The result in 2007 was that some 1.3 million homes were being foreclosed upon. By May 21st, 2008 a total of $379 billion had been reported as 'losses' by banks and financial institutions. This is a result partly of subprime mortgages, whose values was $1.3 trillion in 2007. On April 2nd, 2007 New Century Financial, the largest sub-prime mortgage lender in the U.S, filed for bankruptcy. American Home Mortgage followed on August 6th and by August 16th it was unclear whether Countrywide, another large lender, would stay afloat (in the end it survived). On the 12th of September, 2007 a lender named Northern Rock became the first non-U.S casualty of the crises when it applied to Bank of England for a bailout. On May 16th, 2008 Bear Stearns, a leading investment house, was purchased for $2 a share by J.P. Morgan, after it seemed to be heading towards insolvency due to the crises. Other major lenders such as Washington Mutual have been beaten down by the crises. Banks throughout the world have had to 'write down' the losses associated with these sub-prime loans. UBS-Ag in Switzerland reported a loss of $37 billion while Credit Agricole in France reported $4.8 billion in losses. Citigroup was the largest loser with $39 billion in losses. The ripple affect has harmed brokerage houses as well, causing liquidity scares at firms such as Lehman Brothers (which reported $3.93 billion in losses). Some firms have dodged the bullet, such as Goldman Sachs. The question every investor and financial institution is asking is 'when will the ripple affect end?' With new disclosures every week it seems that the answer will not be known for some time.
The headlines from CNBC on June 26th, 2008 seem to highlight the crises. Warren Buffet says inflation is 'exploding'. Goldman Sachs warns of further write downs at Citigroup and Merrill Lynch. The Fed is 'worried about inflation' but has not issued a change in its benchmark Federal Funds rate, leaving it at 2%. A sidebar on the website announces the 'death of the U.S dollar'. The DOW (Dow Jones Industrial Average, the leading indicator of the U.S stock market) reached 14,000 on October 12th, 2007. Today, in June of 2008, it is at 11,800. In 1998 it was at 8,900. No sign of a crises there.
The truth is that all the leading indicators do not spell the 'death' of the U.S dollar, or a period of 'hyperinflation' or 'skyrocketing oil' prices that will reach $1,000 a barrel. The resilience of the U.S stock market in the face of the mortgage crises and the 'credit crunch' has been surprising and means that the crises itself is quite shallow. The diversity of the market is such as that the loss of $380 billion has not caused a meltdown. This would have been unthinkable 20 years ago and certainly 80 years ago (2009 is the 80th anniversary of the Great Crash of 1929). But the U.S market as been through the '.com' bubble of the late 1990s and 2000, the period of 'irrational exuberance' as Alan Greenspan called it. The market not only survived that but it also survived the shock of 9/11. The American investor has become less skittish and the various controls placed on the market over the years, in terms of lessoning the affects of a short term panic (such as the computer selling or program trading that caused the 1987 crash when the DOW lost 22% in one day, between 1929 and 1932 the DOW lost 89% of its value from 381 points to 41) have proved successful. In fact just such a strange 'black swan' event seemed to jar the market a year ago when it suddenly dropped three hundred points for no apparent reason, only to recover in the following days. Americans are not panicking, yet. When compared to past events, such as the Oil shock of the 1970s, the S&L crises or the period of stagflation under Richard Nixon and double digit inflation under Jimmy Carter there is nothing particularly unique about the 'crises' facing the economy. The only unique factor may be the snowballing of so many negative indicators. But there may be a silver lining. The rise in oil prices should encourage American industry and the government to build new energy efficient cars and develop new energy sources. The decline of the dollar is a positive development for American exports, which may lesson the trade deficit, which is one of the factors behind a weak dollar.