Stabilize House Prices, Part 6

Over the past several months, economists have been coming up with one proposal after another in an attempt to stabilize falling home prices. This blog has reviewed several of them starting here.

It is clear that, despite the various proposals, the previous administration did very little to alleviate the problem. It’s also clear that it is now a matter of some urgency for the new Obama administration.

The February 19th New York Times article, $275 Billion Plan Seeks to Address Housing Crisis leads with this, “President Obama announced a plan on Wednesday to help as many as nine million American homeowners refinance their mortgages or avert foreclosure, saying that it would shore up housing prices, stabilize neighborhoods and slow a downward spiral released his proposal…” and summarizes it as follows:

The plan has three components. The first would help homeowners who are still current on their payments, but who are paying high interest rates and cannot refinance because they do not have enough equity in their homes, a problem afflicting growing numbers of people as housing values tumble.

A second component would assist about four million people who are at risk of losing their homes. It would provide incentives to lenders who alter the terms of loans to make them affordable for the troubled borrowers. A third component would try to increase the credit available for mortgages in general by giving $200 billion of additional financial backing to Fannie Mae and Freddie Mac.

Beyond luring lenders with government money, the plan also calls on Congress to give bankruptcy judges the power to change the terms of mortgages and reduce the monthly payments.

Questions of fairness and efficacy were immediately raised. While some have criticized the plan as not doing enough, Edward L. Glaeser, a Harvard University economist, believes that one virtue is that it does not try to solve every problem.

For his assessment of the advantages and shortcomings of the Obama initiative, read Housing Plan: The Virtues of Moderation which was published online.

Conclusion

In my opinion, most of the issues facing the Obama administration (and therefore all U.S. citizens) are more complicated than it first appears. Given the depth and breadth of our financial problems, we need reasoned arguments and a nuanced assessment of any new plan. We do not need knee-jerk responses, either pro or con.

Whatever the proposal on the table, there is always room for improvement, and certainly, more initiatives will be needed. We desperately need constructive criticism and cooperation. Professor Glaeser’s analysis delivers a useful starting point.

How to Repair a Broken Financial World

The previous post, The End of the Financial World as We Know It, wrote about short-term incentives operating at investment firms, credit rating agencies, the Securities and Exchange Commission and the U.S. Treasury Department.

In How to Repair a Broken Financial World, Michael Lewis and David Einhorn lay out their policy prescriptions.

There are other things the Treasury might do when a major financial firm assumed to be “too big to fail” comes knocking, asking for free money. Here’s one: Let it fail.

Not as chaotically as Lehman Brothers was allowed to fail. If a failing firm is deemed “too big” for that honor, then it should be explicitly nationalized, both to limit its effect on other firms and to protect the guts of the system. Its shareholders should be wiped out, and its management replaced. Its valuable parts should be sold off as functioning businesses to the highest bidders — perhaps to some bank that was not swept up in the credit bubble. The rest should be liquidated, in calm markets. Do this and, for everyone except the firms that invented the mess, the pain will likely subside.

This is more plausible than it may sound. Sweden, of all places, did it successfully in 1992. And remember, the Federal Reserve and the Treasury have already accepted, on behalf of the taxpayer, just about all of the downside risk of owning the bigger financial firms.

If we are going to spend trillions of dollars of taxpayer money, it makes more sense to focus less on the failed institutions at the top of the financial system and more on the individuals at the bottom. Instead of buying dodgy assets and guaranteeing deals that should never have been made in the first place, we should use our money to A) repair the social safety net, now badly rent in ways that cause perfectly rational people to be terrified; and B) transform the bailout of the banks into a rescue of homeowners.

There are also a handful of other perfectly obvious changes in the financial system to be made, to prevent some version of what has happened from happening all over again. A short list:

Stop making big regulatory decisions with long-term consequences based on their short-term effect on stock prices. Stock prices go up and down: let them. An absurd number of the official crises have been negotiated and resolved over weekends so that they may be presented as a fait accompli “before the Asian markets open.” The hasty crisis-to-crisis policy decision-making lacks coherence for the obvious reason that it is more or less driven by a desire to please the stock market. The Treasury, the Federal Reserve and the S.E.C. all seem to view propping up stock prices as a critical part of their mission — indeed, the Federal Reserve sometimes seems more concerned than the average Wall Street trader with the market’s day-to-day movements. If the policies are sound, the stock market will eventually learn to take care of itself.

End the official status of the rating agencies. Given their performance it’s hard to believe credit rating agencies are still around. There’s no question that the world is worse off for the existence of companies like Moody’s and Standard & Poor’s. There should be a rule against issuers paying for ratings. Either investors should pay for them privately or, if public ratings are deemed essential, they should be publicly provided.

Regulate credit-default swaps. There are now tens of trillions of dollars in these contracts between big financial firms. An awful lot of the bad stuff that has happened to our financial system has happened because it was never explained in plain, simple language. Financial innovators were able to create new products and markets without anyone thinking too much about their broader financial consequences — and without regulators knowing very much about them at all. It doesn’t matter how transparent financial markets are if no one can understand what’s inside them. Until very recently, companies haven’t had to provide even cursory disclosure of credit-default swaps in their financial statements.

Credit-default swaps may not be Exhibit No. 1 in the case against financial complexity, but they are useful evidence. Whatever credit defaults are in theory, in practice they have become mainly side bets on whether some company, or some subprime mortgage-backed bond, some municipality, or even the United States government will go bust. In the extreme case, subprime mortgage bonds were created so that smart investors, using credit-default swaps, could bet against them. Call it insurance if you like, but it’s not the insurance most people know. It’s more like buying fire insurance on your neighbor’s house, possibly for many times the value of that house — from a company that probably doesn’t have any real ability to pay you if someone sets fire to the whole neighborhood. The most critical role for regulation is to make sure that the sellers of risk have the capital to support their bets.

Impose new capital requirements on banks. … A better idea would be to require banks to hold less capital in bad times and more capital in good times. Now that we have seen how too-big-to-fail financial institutions behave, it is clear that relieving them of stringent requirements is not the way to go.

Another good solution to the too-big-to-fail problem is to break up any institution that becomes too big to fail.

Close the revolving door between the S.E.C. and Wall Street. At every turn we keep coming back to an enormous barrier to reform: Wall Street’s political influence. Its influence over the S.E.C. is further compromised by its ability to enrich the people who work for it. Realistically, there is only so much that can be done to fix the problem, but one measure is obvious: forbid regulators, for some meaningful amount of time after they have left the S.E.C., from accepting high-paying jobs with Wall Street firms.

But keep the door open the other way. If the S.E.C. is to restore its credibility as an investor protection agency, it should have some experienced, respected investors (which is not the same thing as investment bankers) as commissioners. President-elect Barack Obama should nominate at least one with a notable career investing capital, and another with experience uncovering corporate misconduct. As it happens, the most critical job, chief of enforcement, now has a perfect candidate, a civic-minded former investor with firsthand experience of the S.E.C.’s ineptitude: Harry Markopolos.

The funny thing is, there’s nothing all that radical about most of these changes. A disinterested person would probably wonder why many of them had not been made long ago. A committee of people whose financial interests are somehow bound up with Wall Street is a different matter.

Conclusion

The articles by Michael Lewis and David Einhorn are well written, providing extremely useful context. And they make very sensible recommendations. However, the “Financial Crisis” goes well beyond the United States. Any negative effects felt within the U.S. economy quickly spread far and wide. As we know now, the sub-prime problem in the U.S. negatively impacted the economies of many countries, even bankrupting the economy of Iceland.

Therefore any comprehensive solution needs to encompass all of the intertwined global economies. We cannot solve our economic problems on a nation by nation basis. A global approach to monitoring (and regulating) the financial sector is essential in order to avoid another “Financial Crisis.”

The End of the Financial World as We Know It

“The Madoff scandal echoes a deeper absence inside our financial system, which has been undermined not merely by bad behavior but by the lack of checks and balances to discourage it. Greed doesn’t cut it as a satisfying explanation for the current financial crisis. … The fixable problem isn’t the greed of the few but the misaligned interests of the many.” – Michael Lewis and David Einhorn.

To arrive at the solution to any question, you first need to understand the extent, nature and causes of the problem. This is especially true with respect to the continuing and escalating “Financial Crisis” (now, unfortunately, worthy of capital letters and quotations), primarily because we just don’t have a playbook to refer to. Worse still, the “Financial Crisis” has morphed into a full-blown economic recession.

Previous posts have emphasized different aspects of the economic meltdown. Here’s another perspective. In two related articles published in the New York Times, Michael Lewis and David Einhorn have written in-depth about both the causes of our current problem and their recommended solutions.

The End of the Financial World as We Know It uses the Madoff scandal as a starting point to illustrate the perverse incentives operating at investment firms, credit rating agencies, the Securities and Exchange Commission and the U.S. Treasury Department.

Wall Street Firms

…leaders of public corporations, especially financial corporations, are as good as required to lead for the short term.

Our financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense.

Credit Ratings Agencies

Everyone now knows that Moody’s and Standard & Poor’s botched their analyses of bonds backed by home mortgages. But their most costly mistake — one that deserves a lot more attention than it has received — lies in their area of putative expertise: measuring corporate risk.

These oligopolies, which are actually sanctioned by the S.E.C., didn’t merely do their jobs badly. They didn’t simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: rather than expose financial risk they systematically disguised it.

The Securities and Exchange Commission

… the S.E.C. itself is plagued by similarly wacky incentives. Indeed, one of the great social benefits of the Madoff scandal may be to finally reveal the S.E.C. for what it has become.

Created to protect investors from financial predators, the commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors. (The task it has performed most diligently during this crisis has been to question, intimidate and impose rules on short-sellers — the only market players who have a financial incentive to expose fraud and abuse.)

The instinct to avoid short-term political heat is part of the problem; anything the S.E.C. does to roil the markets, or reduce the share price of any given company, also roils the careers of the people who run the S.E.C. Thus it seldom penalizes serious corporate and management malfeasance — out of some misguided notion that to do so would cause stock prices to fall, shareholders to suffer and confidence to be undermined. Preserving confidence, even when that confidence is false, has been near the top of the S.E.C.’s agenda.

It’s not hard to see why the S.E.C. behaves as it does. If you work for the enforcement division of the S.E.C. you probably know in the back of your mind, and in the front too, that if you maintain good relations with Wall Street you might soon be paid huge sums of money to be employed by it.

The U.S. Treasury

Say what you will about our government’s approach to the financial crisis, you cannot accuse it of wasting its energy being consistent or trying to win over the masses. In the past year there have been at least seven different bailouts, and six different strategies. And none of them seem to have pleased anyone except a handful of financiers.

… Treasury Secretary Henry M. Paulson Jr. persuaded Congress that he needed $700 billion to buy distressed assets from banks — telling the senators and representatives that if they didn’t give him the money the stock market would collapse. Once handed the money, he abandoned his promised strategy, and instead of buying assets at market prices, began to overpay for preferred stocks in the banks themselves. Which is to say that he essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs and a few others unnaturally selected for survival. The stock market fell anyway.

It’s hard to know what Mr. Paulson was thinking as he never really had to explain himself, at least not in public. But the general idea appears to be that if you give the banks capital they will in turn use it to make loans in order to stimulate the economy. Never mind that if you want banks to make smart, prudent loans, you probably shouldn’t give money to bankers who sunk themselves by making a lot of stupid, imprudent ones. If you want banks to re-lend the money, you need to provide them not with preferred stock, which is essentially a loan, but with tangible common equity — so that they might write off their losses, resolve their troubled assets and then begin to make new loans, something they won’t be able to do until they’re confident in their own balance sheets. But as it happened, the banks took the taxpayer money and just sat on it.

To be continued.

Professor Explains Financial Crisis, Part 2

The last post highlighted an article by Alan S. Blinder, professor of Economics and Public Affairs at Princeton University, which briefly summarized the causes of the Financial Crisis.

What Really Lies Behind the Financial Crisis? summarizes a 90-minute talk by Jeremy Siegel, a professor of Finance at the Wharton School. The two professors both blame government policy mistakes. However, Siegel adds Fed Reserve Chairman Alan Greenspan to the list of people who could have made better choices. Professor Siegel also focuses on the role of financial institutions in causing the crisis.

What was the true cause of the worst financial crisis the world has seen since the Great Depression? Was it excessive greed on Wall Street? Was it mark-to-market accounting? The answer is none of the above, says Jeremy Siegel, a professor of finance at Wharton. While these factors contributed to the crisis, they do not represent its most significant cause.

Financial firms bought, held and insured large quantities of risky, mortgage-related assets on borrowed money.

Many troubled banks and insurers continued to prosper in almost every other aspect of their businesses right up to the 2008 meltdown. The exception was the billions of dollars in mortgage-backed securities that they bought and held on to or insured even after U.S. home prices went into a free-fall more than two years ago. American International Group (AIG), the insurer that received an $85 billion federal rescue package last September, is a prime example. Some 95% of its business units were profitable when the company collapsed. “AIG has 125,000 employees,” Siegel noted. “Basically, 80 of them tanked the firm. It was the New Products Division, which had an office in London and a small branch office in Connecticut. They came up with the idea of insuring mortgage-backed assets, and nobody at the top decided it wasn’t a good idea. So they bet the house — and the company went under.”

Lapse over Lehman

According to Siegel, federal officials — particularly outgoing Treasury Secretary Henry Paulson ­– mishandled initial efforts to intervene in the crisis. For example, Paulson was concerned about the political backlash that might be unleashed by bailing out Lehman Brothers. He allowed the firm to collapse last September but underestimated the impact of Lehman’s demise on financial markets. Despite a $700 billion bailout, banks are still unwilling to extend credit.

While angry investors and taxpayers are anxiously looking to assign blame for the current state of the economy, it’s important to know not only which factors led to the meltdown, but which ones did not. He said that government programs encouraging home-buying by low- and middle-income families and short-selling of financial stocks — which was halted for a time last fall — have little to do with the crisis on Wall Street.

Instead, Siegel pointed to two interlocking issues: One is a massive failure, not only by traders, but by CEOs of financial firms, their risk management specialists and the major rating agencies to recognize that an unprecedented housing-price bubble began building after 2000. Their faulty reasoning was that the inability of homeowners to pay their mortgages — and the consequent foreclosures — would not pose a threat to their mortgage-backed securities. They believed that as long as home prices kept rising, the underlying value of the real estate would provide a hedge against the risk of such defaults. They failed to realize that this reasoning was based on the assumption that home prices would go in just one direction — up. In fact, these assets became enormously risky once the housing bubble burst and home prices began their inevitable decline.

Siegel also argued that ultimately, the buck stops with corporate CEOs who didn’t ask hard enough questions about the risks posed by mortgage-backed assets. He said he and others have wondered why firms like Lehman Brothers, Bear Stearns and Morgan Stanley — which survived the much more severe Great Depression of the 1930s — collapsed during 2008. One reason, he suggested, might be that, back then, these firms were organized as partnerships. In such an organizational structure, the partners would have to risk their own capital. When the partnerships were reorganized as widely held public companies, however, they no longer had such constraints. “Back when it was a partnership, you had your life invested in that company,” said Siegel, noting that banks also began making higher-return but higher-risk investments in recent years as public ownership increased.

Greenspan’s Role

One other key player that Siegel criticized for not heading off the collapse of the mortgage-backed securities is former Federal Reserve chairman Alan Greenspan, who oversaw the government’s central bank until 2006. Greenspan was so influential while he oversaw the Fed that he could have easily blown the whistle on the over-accumulation of mortgage-backed assets by the U.S.-based financial giants. He, however, failed to discover that firms were taking such large, risky individual stakes without protecting themselves against a housing market collapse. “[Greenspan was] the greatest central banker in history — he had access to every piece of data,” Siegel said. “He could have looked at the balance sheets of Morgan Stanley or Citigroup and said, ‘Oh my God — they didn’t neutralize their risk.’”

Another reason why federal officials and economists failed to detect the perilous economic risks of the 2000s, Siegel said, is the so-called “Great Moderation.” This term refers to the fact that since the 1980s, the volatility of the business cycle has declined, thanks to more aggressive fiscal policy and the rise of a service-based economy, among other factors. Siegel noted that a similar flattening of the economic cycles had occurred during the 1920s after the 1913 establishment of the Federal Reserve Bank, a factor that caused stock investors to ignore risks, which eventually led to the stock market crash of 1929 and the Great Depression.

“People asked, ‘Are we ever going to have a big recession again?’” Siegel said of today’s policy makers. “Everybody thought we were in a new stage and risk premiums didn’t need to be so high.” But those risks hit home last year. While it would have been difficult for federal regulators to save Lehman Brothers — which had invested billions of dollars in assets related to subprime mortgages — even if they had acted six months sooner, the fall of the 158-year-old financial house had a disastrous impact on the wider financial market. Lehman Brothers was connected to 950,000 or so transactions. As a result, bankers became gun-shy about making any type of loan, even to companies with a flawless credit history.

Trouble with TARP

For that reason, Siegel said, the initial phase of the Bush administration’s Troubled Asset Relief Program (TARP) was seriously flawed. Paulson’s Treasury Department decided to buy equity stakes in troubled banks, assuming they would make more loans with more capital on hand. The amount of capital, though, has little to do with the reluctance of banks to make loans, even as the rate on federal funds is slashed to near zero. John Maynard Keynes, the British economist, called this situation a “liquidity trap,” Siegel noted. “The big failure of TARP was that it misunderstood why banks weren’t lending. Officials thought it was because they didn’t have enough capital. In reality, they were worried about the solvency of all the borrowing that was out there.” Siegel suggested that the government rescue plan could be improved with guarantees that recipients demonstrate they are using the federal dollars to extend credit.

According to Siegel, monetary policy has failed to stimulate the U.S. economy. The U.S. faces a situation similar to what happened in Japan during the 1990s when interest rates of zero could not revive the country’s moribund financial markets. The only viable solution now open to American policy makers is Keynesian fiscal policy, a stimulus program that lowers taxes or increases government spending or both. Indeed, this is exactly the type of program — costing at least $825 billion — that the Obama administration and Senate Democrats are considering. Siegel said that policymakers should not worry about the impact on deficits; it is large, he added, but not dangerously so.

Professor Explains Financial Crisis, Part 1

In his January 24th New York Times column, Six Errors on the Path to the Financial Crisis, Alan S. Blinder, professor of Economics and Public Affairs at Princeton University, briefly summarizes the causes of the Financial Crisis. He uses a chronological approach, listing the decisions (and the alternative advice that was ignored).

According to Blinder, the cause of our troubles “was largely a series of avoidable — yes, avoidable — human errors. Recognizing and understanding these errors will help us fix the system so that it doesn’t malfunction so badly again.”

Here is a summary of his article.

Wild Derivatives. Rather than regulate these arcane financial instruments, as Brooksley E. Born, then chairwoman of the Commodity Futures Trading Commission recommended in 1998, “top officials of the Treasury Department, the Federal Reserve and the Securities and Exchange Commission squelched the idea. … Does anyone doubt that the financial turmoil would have been less severe if derivatives trading had acquired a zookeeper a decade ago?”

Sky-High Leverage.  In 2004, the S.E.C. let securities firms raise their leverage sharply. Had leverage stayed at previous levels, “these firms wouldn’t have grown as big or been as fragile.”

A Subprime Surge. “The next error came in stages, from 2004 to 2007, as subprime lending grew from a small corner of the mortgage market into a large, dangerous one. Lending standards fell disgracefully, and dubious transactions became common.”

Foreclosures. “The government’s continuing failure to do anything large and serious to limit foreclosures is tragic. …Free-market ideology, denial and an unwillingness to commit taxpayer funds all played roles. Sadly, the problem should now be much smaller than it is.”

Letting Lehman Go. “The next whopper came in September, when Lehman Brothers, unlike Bear Stearns before it, was allowed to fail. … Everything fell apart after Lehman.”

“After Lehman went over the cliff, no financial institution seemed safe. So lending froze, and the economy sank like a stone. It was a colossal error, and many people said so at the time.”

TARP’S Detour. “The final major error is mismanagement of the Troubled Asset Relief Program, the $700 billion bailout fund. … Instead of pursuing the TARP’s intended purposes, (Henry M. Paulson Jr., the former Treasury Secretary), used most of the funds to inject capital into banks — which he did poorly.”

Conclusion

Six fateful decisions — all made the wrong way. Imagine what the world would be like now if the housing bubble burst but those six things were different: if derivatives were traded on organized exchanges, if leverage were far lower, if subprime lending were smaller and done responsibly, if strong actions to limit foreclosures were taken right away, if Lehman were not allowed to fail, and if the TARP funds were used as directed.

All of this was possible. And if history had gone that way, I believe that the financial world and the economy would look far less grim than they do today.

How Citigroup Got Into Trouble

“Risk comes from not knowing what you’re doing.” – Warren Buffett.

In previous posts, I wrote about the poor job some investment banks did in risk management and how they ended up “owning exotic securities, derivatives, pieces of paper backed by pools of assets. They did not understand these securities any better than the people they sold them to.

An article in today’s New York Times, The Reckoning – Citigroup Pays for a Rush to Risk, by Eric Dash and Julie Creswell goes behind the scenes to explain just how bad things were. What is fascinating is that the article names names, i.e. the people who were trading the securities and the risk managers, who failed to rein them in.

Of course, top management was ultimately responsible for the debacle.  Looking back, one question comes to mind, “What were they thinking?” The authors answer that question.

Here are extensive quotes from the article.

In September 2007, with Wall Street confronting a crisis caused by too many souring mortgages, Citigroup executives gathered in a wood-paneled library to assess their own well-being.

There, Citigroup’s chief executive, Charles O. Prince III, learned for the first time that the bank owned about $43 billion in mortgage-related assets. He asked Thomas G. Maheras, who oversaw trading at the bank, whether everything was O.K.

Mr. Maheras told his boss that no big losses were looming, according to people briefed on the meeting who would speak only on the condition that they not be named.

For months, Mr. Maheras’s reassurances to others at Citigroup had quieted internal concerns about the bank’s vulnerabilities. But this time, a risk-management team was dispatched to more rigorously examine Citigroup’s huge mortgage-related holdings. They were too late, however: within several weeks, Citigroup would announce billions of dollars in losses.

Normally, a big bank would never allow the word of just one executive to carry so much weight. Instead, it would have its risk managers aggressively look over any shoulder and guard against trading or lending excesses.

But many Citigroup insiders say the bank’s risk managers never investigated deeply enough. Because of longstanding ties that clouded their judgment, the very people charged with overseeing deal makers eager to increase short-term earnings — and executives’ multimillion-dollar bonuses — failed to rein them in, these insiders say.

Today, Citigroup, once the nation’s largest and mightiest financial institution, has been brought to its knees by more than $65 billion in losses, write-downs for troubled assets and charges to account for future losses. More than half of that amount stems from mortgage-related securities created by Mr. Maheras’s team — the same products Mr. Prince was briefed on during that 2007 meeting.

Citigroup’s stock has plummeted to its lowest price in more than a decade, closing Friday at $3.77. At that price the company is worth just $20.5 billion, down from $244 billion two years ago. Waves of layoffs have accompanied that slide, with about 75,000 jobs already gone or set to disappear from a work force that numbered about 375,000 a year ago.

While much of the damage inflicted on Citigroup and the broader economy was caused by errant, high-octane trading and lax oversight, critics say, blame also reaches into the highest levels at the bank. Earlier this year, the Federal Reserve took the bank to task for poor oversight and risk controls in a report it sent to Citigroup.

The bank’s downfall was years in the making and involved many in its hierarchy, particularly Mr. Prince and Robert E. Rubin, an influential director and senior adviser.

Citigroup insiders and analysts say that Mr. Prince and Mr. Rubin played pivotal roles in the bank’s current woes, by drafting and blessing a strategy that involved taking greater trading risks to expand its business and reap higher profits. Mr. Prince and Mr. Rubin both declined to comment for this article.

For a time, Citigroup’s megabank model paid off handsomely, as it rang up billions in earnings each quarter from credit cards, mortgages, merger advice and trading.

But when Citigroup’s trading machine began churning out billions of dollars in mortgage-related securities, it courted disaster. As it built up that business, it used accounting maneuvers to move billions of dollars of the troubled assets off its books, freeing capital so the bank could grow even larger. Because of pending accounting changes, Citigroup and other banks have been bringing those assets back in-house, raising concerns about a new round of potential losses.

To some, the misery at Citigroup is no surprise. Lynn Turner, a former chief accountant with the Securities and Exchange Commission, said the bank’s balkanized culture and pell-mell management made problems inevitable.

“If you’re an entity of this size,” he said, “if you don’t have controls, if you don’t have the right culture and you don’t have people accountable for the risks that they are taking, you’re Citigroup.”

Questions on Oversight

Though they carry less prestige and are paid less than Wall Street traders and bankers, risk managers can wield significant clout. Their job is to monitor trading floors and inquire about how a bank’s money is being invested, so they can head off potential problems before blow-ups occur. Though risk managers and traders work side by side, they can have an uncomfortable coexistence because the monitors can put a brake on trading.

That is the way it works in theory. But at Citigroup, many say, it was a bit different.

David C. Bushnell was the senior risk officer who, with help from his staff, was supposed to keep an eye on the bank’s bond trading business and its multibillion-dollar portfolio of mortgage-backed securities. Those activities were part of what the bank called its fixed-income business, which Mr. Maheras supervised.

One of Mr. Maheras’s trusted deputies, Randolph H. Barker, helped oversee the huge build-up in mortgage-related securities at Citigroup. But Mr. Bushnell, Mr. Maheras and Mr. Barker were all old friends, having climbed the bank’s corporate ladder together.

Because Mr. Bushnell had to monitor traders working for Mr. Barker’s bond desk, their friendship raised eyebrows inside the company among those concerned about its controls.

After all, traders’ livelihoods depended on finding new ways to make money, sometimes using methods that might not be in the bank’s long-term interests. But insufficient boundaries were established in the bank’s fixed-income unit to limit potential conflicts of interest involving Mr. Bushnell and Mr. Barker, people inside the bank say.

Indeed, some at Citigroup say that if traders or bankers wanted to complete a potentially profitable deal, they could sometimes rely on Mr. Barker to convince Mr. Bushnell that it was a risk worth taking.

Risk management “has to be independent, and it wasn’t independent at Citigroup, at least when it came to fixed income,” said one former executive in Mr. Barker’s group who, like many other people interviewed for this article, insisted on anonymity because of pending litigation against the bank or to retain close ties to their colleagues. “We used to say that if we wanted to get a deal done, we needed to convince Randy first because he could get it through.”

Others say that Mr. Bushnell’s friendship with Mr. Maheras may have presented a similar blind spot.

“Because he has such trust and faith in these guys he has worked with for years, he didn’t ask the right questions,” a former senior Citigroup executive said, referring to Mr. Bushnell.”

According to a former Citigroup executive, Mr. Prince started putting pressure on Mr. Maheras and others to increase earnings in the bank’s trading operations, particularly in the creation of collateralized debt obligations, or C.D.O.’s — securities that packaged mortgages and other forms of debt into bundles for resale to investors.

Because C.D.O.’s included so many forms of bundled debt, gauging their risk was particularly tricky; some parts of the bundle could be sound, while others were vulnerable to default.

“Chuck Prince going down to the corporate investment bank in late 2002 was the start of that process,” a former Citigroup executive said of the bank’s big C.D.O. push. “Chuck was totally new to the job. He didn’t know a C.D.O. from a grocery list, so he looked for someone for advice and support. That person was Rubin. And Rubin had always been an advocate of being more aggressive in the capital markets arena. He would say, ‘You have to take more risk if you want to earn more.’ “

It appeared to be a good time for building up Citigroup’s C.D.O. business. As the housing market around the country took flight, the C.D.O. market also grew apace as more and more mortgages were pooled together into newfangled securities.

From 2003 to 2005, Citigroup more than tripled its issuing of C.D.O.’s, to more than $20 billion from $6.28 billion, and Mr. Maheras, Mr. Barker and others on the C.D.O. team helped transform Citigroup into one of the industry’s biggest players. Firms issuing the C.D.O.’s generated fees of 0.4 percent to 2.5 percent of the amount sold — meaning Citigroup made up to $500 million in fees from the business in 2005 alone.

Even as Citigroup’s C.D.O. stake was expanding, its top executives wanted more profits from that business. Yet they were not running a bank that was up to all the challenges it faced, including properly overseeing billions of dollars’ worth of exotic products, according to Citigroup insiders and regulators who later criticized the bank.
 

In 2005, as Citigroup began its effort to expand from within, Mr. Rubin peppered his colleagues with questions as they formulated the plan. According to current and former colleagues, he believed that Citigroup was falling behind rivals like Morgan Stanley and Goldman, and he pushed to bulk up the bank’s high-growth fixed-income trading, including the C.D.O. business.

Former colleagues said Mr. Rubin also encouraged Mr. Prince to broaden the bank’s appetite for risk, provided that it also upgraded oversight — though the Federal Reserve later would conclude that the bank’s oversight remained inadequate.

Once the strategy was outlined, Mr. Rubin helped Mr. Prince gain the board’s confidence that it would work.

After that, the bank moved even more aggressively into C.D.O.’s. It added to its trading operations and snagged crucial people from competitors. Bonuses doubled and tripled for C.D.O. traders. Mr. Barker drew pay totaling $15 million to $20 million a year, according to former colleagues, and Mr. Maheras became one of Citigroup’s most highly compensated employees, earning as much as $30 million at the peak — far more than top executives like Mr. Bushnell in the risk-management department.

In December 2005, with Citigroup diving into the C.D.O. business, Mr. Prince assured analysts that all was well at his bank.

“Anything based on human endeavor and certainly any business that involves risk-taking, you’re going to have problems from time to time,” he said. “We will run our business in a way where our credibility and our reputation as an institution with the public and with our regulators will be an asset of the company and not a liability.”

Yet as the bank’s C.D.O. machine accelerated, its risk controls fell further behind, according to former Citigroup traders, and risk managers lacked clear lines of reporting. At one point, for instance, risk managers in the fixed-income division reported to both Mr. Maheras and Mr. Bushnell — setting up a potential conflict because that gave Mr. Maheras influence over employees who were supposed to keep an eye on his traders.

C.D.O.’s were complex, and even experienced managers like Mr. Maheras and Mr. Barker underestimated the risks they posed, according to people with direct knowledge of Citigroup’s business. Because of that, they put blind faith in the passing grades that major credit-rating agencies bestowed on the debt.

While the sheer size of Citigroup’s C.D.O. position caused concern among some around the trading desk, most say they kept their concerns to themselves.

“I just think senior managers got addicted to the revenues and arrogant about the risks they were running,” said one person who worked in the C.D.O. group. “As long as you could grow revenues, you could keep your bonus growing.”

To make matters worse, Citigroup’s risk models never accounted for the possibility of a national housing downturn, this person said, and the prospect that millions of homeowners could default on their mortgages. Such a downturn did come, of course, with disastrous consequences for Citigroup and its rivals on Wall Street.

Even as the first shock waves of the subprime mortgage crisis hit Bear Stearns in June 2007, Citigroup’s top executives expressed few concerns about their bank’s exposure to mortgage-linked securities.

In fact, when examiners from the Securities and Exchange Commission began scrutinizing Citigroup’s subprime mortgage holdings after Bear Stearns’s problems surfaced, the bank told them that the probability of those mortgages defaulting was so tiny that they excluded them from their risk analysis, according to a person briefed on the discussion who would speak only without being named.

Meanwhile, regulators have criticized the banking industry as a whole for relying on outsiders — in particular the ratings agencies — to help them gauge the risk of their investments.

“There is really no excuse for institutions that specialize in credit risk assessment, like large commercial banks, to rely solely on credit ratings in assessing credit risk,” John C. Dugan, the head of the Office of the Comptroller of the Currency, the chief federal bank regulator, said in a speech earlier this year.

But he noted that what caused the largest problem for some banks was that they retained dangerously big positions in certain securities — like C.D.O.’s — rather than selling them off to other investors.

“What most differentiated the companies sustaining the biggest losses from the rest was their willingness to hold exceptionally large positions on their balance sheets which, in turn, led to exceptionally large losses,” he said.

In fact, some analysts say they believe that the $25 billion that the federal government invested in Citigroup this fall might not be enough to stabilize it.

Others say the fact that such huge amounts have yet to steady the bank is a reflection of the severe damage caused by Citigroup’s appetites.

“They pushed to get earnings, but in doing so, they took on more risk than they probably should have if they are going to be, in the end, a bank subject to regulatory controls,” said Roy Smith, a professor at the Stern School of Business at New York University. “Safe and soundness has to be no less important than growth and profits but that was subordinated by these guys.”

photo credit: TheTruthAbout…

Understanding the Financial Crisis, Part 4

“The right blames the credit crisis on poor minority homeowners. This is not merely offensive, but entirely wrong.”… “Lending money to poor people doesn’t make you poor. Lending money poorly to rich people does.” – Daniel Gross.

In previous posts, I covered the causes of the Financial Crisis: poor mortgage lending standards, excessive risk taking by investment banks, and inadequate transparency and regulation. Not discussed in any detail is the role of government policy in causing the financial meltdown.

According to Daniel Gross writing on the web site Slate, the right wing claims the cause of the current problems is government intervention, i.e. “well meaning” social programs that encouraged home ownership by poor and middle class consumers. Gross strenuously objects to this conclusion.

Since fixing any problem necessitates truly understanding the causes of the problem, I am posting the entire article Subprime Suspects published October 7, 2008. (The original post contains links to various referenced articles.)

We’ve now entered a new stage of the financial crisis: the ritual assigning of blame. It began in earnest with Monday’s congressional roasting of Lehman Bros. CEO Richard Fuld and continued on Tuesday with Capitol Hill solons delving into the failure of AIG. On the Republican side of Congress, in the right-wing financial media (which is to say the financial media), and in certain parts of the op-ed-o-sphere, there’s a consensus emerging that the whole mess should be laid at the feet of Fannie Mae and Freddie Mac, the failed mortgage giants, and the Community Reinvestment Act, a law passed during the Carter administration. The CRA, which was amended in the 1990s and this decade, requires banks—which had a long, distinguished history of not making loans to minorities—to make more efforts to do so.

The thesis is laid out almost daily on the Wall Street Journal editorial page, in the National Review, and on the campaign trail. John McCain said yesterday, “Bad mortgages were being backed by Fannie Mae and Freddie Mac, and it was only a matter of time before a contagion of unsustainable debt began to spread.” Washington Post columnist Charles Krauthammer provides an excellent example, writing that “much of this crisis was brought upon us by the good intentions of good people.” He continues: “For decades, starting with Jimmy Carter’s Community Reinvestment Act of 1977, there has been bipartisan agreement to use government power to expand homeownership to people who had been shut out for economic reasons or, sometimes, because of racial and ethnic discrimination. What could be a more worthy cause? But it led to tremendous pressure on Fannie Mae and Freddie Mac—which in turn pressured banks and other lenders—to extend mortgages to people who were borrowing over their heads. That’s called subprime lending. It lies at the root of our current calamity.” The subtext: If only Congress didn’t force banks to lend money to poor minorities, the Dow would be well on its way to 36,000. Or, as Fox Business Channel’s Neil Cavuto put it, “I don’t remember a clarion call that said: Fannie and Freddie are a disaster. Loaning to minorities and risky folks is a disaster.”

Let me get this straight. Investment banks and insurance companies run by centimillionaires blow up, and it’s the fault of Jimmy Carter, Bill Clinton, and poor minorities?

These arguments are generally made by people who read the editorial page of the Wall Street Journal and ignore the rest of the paper—economic know-nothings whose opinions are informed mostly by ideology and, occasionally, by prejudice. Let’s be honest. Fannie and Freddie, which didn’t make subprime loans but did buy subprime loans made by others, were part of the problem. Poor Congressional oversight was part of the problem. Banks that sought to meet CRA requirements by indiscriminately doling out loans to minorities may have been part of the problem. But none of these issues is the cause of the problem. Not by a long shot. From the beginning, subprime has been a symptom, not a cause. And the notion that the Community Reinvestment Act is somehow responsible for poor lending decisions is absurd.

Here’s why.

The Community Reinvestment Act applies to depository banks. But many of the institutions that spurred the massive growth of the subprime market weren’t regulated banks. They were outfits such as Argent and American Home Mortgage, which were generally not regulated by the Federal Reserve or other entities that monitored compliance with CRA. These institutions worked hand in glove with Bear Stearns and Lehman Brothers, entities to which the CRA likewise didn’t apply. There’s much more. As Barry Ritholtz notes in this fine rant, the CRA didn’t force mortgage companies to offer loans for no money down, or to throw underwriting standards out the window, or to encourage mortgage brokers to aggressively seek out new markets. Nor did the CRA force the credit-rating agencies to slap high-grade ratings on packages of subprime debt.

Second, many of the biggest flameouts in real estate have had nothing to do with subprime lending. WCI Communities, builder of highly amenitized condos in Florida (no subprime purchasers welcome there), filed for bankruptcy in August. Very few of the tens of thousands of now-surplus condominiums in Miami were conceived to be marketed to subprime borrowers, or minorities—unless you count rich Venezuelans and Colombians as minorities. The multiyear plague that has been documented in brilliant detail at IrvineHousingBlog is playing out in one of the least-subprime housing markets in the nation.

Third, lending money to poor people and minorities isn’t inherently risky. There’s plenty of evidence that in fact it’s not that risky at all. That’s what we’ve learned from several decades of microlending programs, at home and abroad, with their very high repayment rates. And as the New York Times recently reported, Nehemiah Homes, a long-running initiative to build homes and sell them to the working poor in subprime areas of New York’s outer boroughs, has a repayment rate that lenders in Greenwich, Conn., would envy. In 27 years, there have been fewer than 10 defaults on the project’s 3,900 homes. That’s a rate of 0.25 percent.

On the other hand, lending money recklessly to obscenely rich white guys, such as Richard Fuld of Lehman Bros. or Jimmy Cayne of Bear Stearns, can be really risky. In fact, it’s even more risky, since they have a lot more borrowing capacity. And here, again, it’s difficult to imagine how Jimmy Carter could be responsible for the supremely poor decision-making seen in the financial system. I await the Krauthammer column in which he points out the specific provision of the Community Reinvestment Act that forced Bear Stearns to run with an absurd leverage ratio of 33 to 1, which instructed Bear Stearns hedge-fund managers to blow up hundreds of millions of their clients’ money, and that required its septuagenarian CEO to play bridge while his company ran into trouble. Perhaps Neil Cavuto knows which CRA clause required Lehman Bros. to borrow hundreds of billions of dollars in short-term debt in the capital markets and then buy tens of billions of dollars of commercial real estate at the top of the market. I can’t find it. Did AIG plunge into the credit-default-swaps business with abandon because Association of Community Organizations for Reform Now members picketed its offices? Please. How about the hundreds of billions of dollars of leveraged loans—loans banks committed to private-equity firms that wanted to conduct leveraged buyouts of retailers, restaurant companies, and industrial firms? Many of those are going bad now, too. Is that Bill Clinton’s fault?

Look: There was a culture of stupid, reckless lending, of which Fannie Mae and Freddie Mac and the subprime lenders were an integral part. But the dumb-lending virus originated in Greenwich, Conn., midtown Manhattan, and Southern California, not Eastchester, Brownsville, and Washington, D.C. Investment banks created a demand for subprime loans because they saw it as a new asset class that they could dominate. They made subprime loans for the same reason they made other loans: They could get paid for making the loans, for turning them into securities, and for trading them—frequently using borrowed capital.

At Monday’s hearing, Rep. John Mica, R-Fla., gamely tried to pin Lehman’s demise on Fannie and Freddie. After comparing Lehman’s small political contributions with Fannie and Freddie’s much larger ones, Mica asked Fuld what role Fannie and Freddie’s failure played in Lehman’s demise. Fuld’s response: “De minimis.”

Lending money to poor people doesn’t make you poor. Lending money poorly to rich people does.

Understanding the Financial Crisis, Part 3

In a previous post, I highlighted Barry Ritholz’s article on how the financial crisis was caused by an “enormous change in lending standards … that took place during the 2002-2007 period. It was more than a subtle shift — it was an abdication of the traditional lending standards that had existed for decades, if not centuries.”

In the November 1st New York Times, Gretchen Morgenson gives details on just how badly one bank behaved during the housing boom. Was There a Loan It Didn’t Like? goes behind the scenes of mortgage lender Washington Mutual.

Briefly, senior mortgage underwriter, Keysha Cooper says she was pressured by bank managers and mortgage brokers “to approve loans, no matter what.”

“At WaMu it wasn’t about the quality of the loans; it was about the numbers,” Ms. Cooper says. “They didn’t care if we were giving loans to people that didn’t qualify. Instead, it was how many loans did you guys close and fund?

When underwriters refused to approve dubious loans, they were punished, she says.

Ms. Cooper started at WaMu in 2003 and lasted three and a half years. At first, she was allowed to do her job, she says. In February 2007, though, the pressure became intense. WaMu executives told employees they were not making enough loans and had to get their numbers up, she says.

“They started giving loan officers free trips if they closed so many loans, fly them to Hawaii for a month,” Ms. Cooper recalls. “One of my account reps went to Jamaica for a month because he closed $3.5 million in loans that month.”

One loan file was filled with so many discrepancies that she felt certain it involved mortgage fraud. She turned the loan down, she says, only to be scolded by her supervisor.

Brokers often tried to bribe Ms. Cooper to approve loans, she says. One offered to pay $900 to send her son to football summer boot camp if she would approve a loan that had been declined by a host of other lenders. “I told him no and not to disrespect me like that again,” Ms. Cooper says.

Hidden fees meant brokers could easily make between $20,000 and $40,000 on a $500,000 loan, Ms. Cooper says.

Ms. Cooper says that loans she turned down were often approved by her superiors. One in particular came back to haunt WaMu.

Vetting a loan one day, Ms. Cooper says she became suspicious when a photograph of the house being bought showed one street address while documents deeper in the file showed a different address. She contacted the appraiser, and recalls that he said that he must have erred and that he would send her the correct documents.

“I was so for sure that it was fraud I wanted to get on an airplane,” Ms. Cooper says.

The $800,000 loan was approved, but not by Ms. Cooper. Six months later, it defaulted, she says. “When they went to foreclose on the house, they found it was an empty lot,” she recalls.

Conclusion

• Ms. Cooper says she was pressured by her managers to approve mortgage loans “no matter what” including  loans that turned out to be fraudulent.
• Kerry K. Killinger, the WaMu chief executive was paid “tens of millions of dollars.”
• “WaMu was seized by federal regulators in late September, the biggest bank failure in the nation’s history.”

photo credit: Jimmy2000

The Financial Crisis: Why Were The Experts Wrong?

“Speculative bubbles are caused by contagious excitement about investment prospects. I find that in casual conversation, many of my mainstream economist friends tell me that they are aware of such excitement, too. But very few will talk about it professionally.” – Robert Shiller.

Robert Shiller is a Professor of Economics and Finance at Yale University and the author of “Irrational Exuberance,” a book that was first published in 2000. In his book, Shiller warned that the stock market had become a bubble and could have a sharp decline, which, of course, it did. In the 2005 update of that bestseller, he stated clearly, “that a catastrophic collapse of the housing and stock markets could be on its way.”

If someone is right once, you could chalk it up to pure luck. But when you’re spot on twice – well, that looks a lot like skill to me.

In today’s edition of The New York Times, in a column entitled Challenging the Crowd in Whispers, Not Shouts, Shiller writes how he felt about going against the consensus, and how many economists might “pull their punches” to avoid being ostracized or at least, losing credibility. This column helps to answer the question Gary Becker and Richard Posner asked: The Financial Crisis: Why Were Warnings Ignored?

Alan Greenspan, the former Federal Reserve chairman, acknowledged in a Congressional hearing last month that he had made an “error” in assuming that the markets would properly regulate themselves, and added that he had no idea a financial disaster was in the making. What’s more, he said the Fed’s own computer models and economic experts simply “did not forecast” the current financial crisis.

Mr. Greenspan’s comments may have left the impression that no one in the world could have predicted the crisis. Yet it is clear that well before home prices started falling in 2006, lots of people were worried about the housing boom and its potential for creating economic disaster. It’s just that the Fed did not take them very seriously.

According to Shiller, the bubble was obvious even to the casual observer.

For example, I clearly remember a taxi driver in Miami explaining to me years ago that the housing bubble there was getting crazy. With all the construction under way, which he pointed out as we drove along, he said that there would surely be a glut in the market and, eventually, a disaster.

But why weren’t the experts at the Fed saying such things? And why didn’t a consensus of economists at universities and other institutions warn that a crisis was on the way?

For the answer, Shiller turns to social psychology and behavioral economics. Briefly, even experts fear ostracism, and many economists use only a limited set of tools regarding speculative bubbles.

The field of social psychology provides a possible answer. In his classic 1972 book, “Groupthink,” Irving L. Janis, the Yale psychologist, explained how panels of experts could make colossal mistakes. People on these panels, he said, are forever worrying about their personal relevance and effectiveness, and feel that if they deviate too far from the consensus, they will not be given a serious role. They self-censor personal doubts about the emerging group consensus if they cannot express these doubts in a formal way that conforms with apparent assumptions held by the group.

Members of the Fed staff were issuing some warnings. But Mr. Greenspan was right: the warnings were not predictions. They tended to be technical in nature, did not offer a scenario of crashing home prices and economic confidence, and tended to come late in the housing boom.

From my own experience on expert panels, I know firsthand the pressures that people — might I say mavericks? — may feel when questioning the group consensus.

I was connected with the Federal Reserve System as a member the economic advisory panel of the Federal Reserve Bank of New York from 1990 until 2004… In my position on the panel, I felt the need to use restraint. While I warned about the bubbles I believed were developing in the stock and housing markets, I did so very gently, and felt vulnerable expressing such quirky views. Deviating too far from consensus leaves one feeling potentially ostracized from the group, with the risk that one may be terminated.

In 2005, in the second edition of my book “Irrational Exuberance,” I stated clearly that a catastrophic collapse of the housing and stock markets could be on its way. I wrote that “significant further rises in these markets could lead, eventually, to even more significant declines,” and that this might “result in a substantial increase in the rate of personal bankruptcies, which could lead to a secondary string of bankruptcies of financial institutions as well,” and said that this could result in “another, possibly worldwide, recession.

I distinctly remember that, while writing this, I feared criticism for gratuitous alarmism. And indeed, such criticism came.

I gave talks in 2005 at both the Office of the Comptroller of the Currency and at the Federal Deposit Insurance Corporation, in which I argued that we were in the middle of a dangerous housing bubble. I urged these mortgage regulators to impose suitability requirements on mortgage lenders, to assure that the loans were appropriate for the people taking them.

The reaction to this suggestion was roughly this: yes, some staff members had expressed such concerns, and yes, officials knew about the possibility that there was a bubble, but they weren’t taking any of us seriously.

I based my predictions largely on the recently developed field of behavioral economics, which posits that psychology matters for economic events. Behavioral economists are still regarded as a fringe group by many mainstream economists. Support from fellow behavioral economists was important in my daring to talk about speculative bubbles.

Speculative bubbles are caused by contagious excitement about investment prospects. I find that in casual conversation, many of my mainstream economist friends tell me that they are aware of such excitement, too. But very few will talk about it professionally.

Why do professional economists always seem to find that concerns with bubbles are overblown or unsubstantiated? I have wondered about this for years, and still do not quite have an answer. It must have something to do with the tool kit given to economists (as opposed to psychologists) and perhaps even with the self-selection of those attracted to the technical, mathematical field of economics. Economists aren’t generally trained in psychology, and so want to divert the subject of discussion to things they understand well. They pride themselves on being rational. The notion that people are making huge errors in judgment is not appealing.

In addition, it seems that concerns about professional stature may blind us to the possibility that we are witnessing a market bubble. We all want to associate ourselves with dignified people and dignified ideas. Speculative bubbles, and those who study them, have been deemed undignified.

In short, Mr. Janis’s insights seem right on the mark. People compete for stature, and the ideas often just tag along.

Stabilize House Prices, Part 5

“Our plan would keep many more Americans in their homes, and put government money into local communities where it would make a difference. By clarifying the true value of each loan, it would also help clarify the value of securities associated with those mortgages, enabling investors to trade them again. Most important, our plan would help stabilize housing prices.” – John D. Geanakoplos and Susan P. Koniak.

I have written in previous posts about various proposals to stem the tide of mortgage foreclosures. Today’s New York Times Op-Ed piece Mortgage Justice Is Blind by John D. Geanakoplos and Susan P. Koniak is the latest entry.

They cover familiar territory, blaming subprime loans and securitization and quickly summarize the problem.

The current American economic crisis, which began with a housing collapse that had devastating consequences for our financial system, now threatens the global economy. But while we are rushing around trying to pick up all the other falling dominos, the housing crisis continues, and must be addressed.

We start with this simple fact: Too many families are being thrown out of their homes when it makes more sense to let them stay by “reworking” their mortgages — adjusting terms to make it possible for the homeowners to meet their responsibilities. In many cases, adjusting loans would help the homeowners and the lenders: the new mortgages would have lower monthly payments that homeowners could afford to pay, and would end up giving the lenders more money than the 50 cents on the dollar that many foreclosure sales are bringing these days.

To arrive at their solution, the authors first focus on the incentives of the “master servicer” which manages the pool of loans that are bundled together. In the old days when one banker lent money to one consumer each knew the other. If the borrower experienced financial difficulty, the lender had the ability and the incentive to renegotiate the mortgage.

With the advent of securitization, it is the “master servicer” who manages hundreds if not thousands of mortgages. They have very little incentive to rework the loans, fearing legal liability from investors. In addition, Geanakoplos and Koniak point out that the servicers will not be adequately compensated for the extra work.

As a result, “the master servicer now holds the power to rework the loans. And, as we have seen in the current crisis, these servicers aren’t doing that, as house after house goes into foreclosure.”
 
To solve this problem, we propose legislation that moves the reworking function from the paralyzed master servicers and transfers it to community-based, government-appointed trustees. These trustees would be given no information about which securities are derived from which mortgages, or how those securities would be affected by the reworking and foreclosure decisions they make.

Instead of worrying about which securities might be harmed, the blind trustees would consider, loan by loan, whether a reworking would bring in more money than a foreclosure. The government expense would be limited to paying for the trustees — no small amount of money, but much cheaper than first paying off the security holders by buying out the loans, which would then have to be reworked anyway. Our plan would also be far more efficient than having judges attempt this role. The trustees would be hired from the ranks of community bankers, and thus have the expertise the judiciary lacks.

Americans have repeatedly been told that the distressed loans cannot be reworked because these mortgages can no longer be “put back together.” But that is not true. Our plan does not require that the loans be reassembled from the securities in which they are now divided, nor does it require the buying up of any loans or securities. It does require the transfer of the servicers’ duty to rework loans to government trustees. It requires that restrictions in some servicing contracts, like those on how many loans can be reworked in each pool, be eliminated when the duty to rework is transferred to the trustees.

Under our plan, servicers would provide the homeowner’s name and other relevant information on each loan to a central government clearing house, which would in turn give trustees the data on homes in their local area. Once the trustees have examined the loans — leaving some unchanged, reworking others and recommending foreclosure on the rest — they would pass those decisions to the government clearing house for transmittal back to the appropriate servicers.

The servicers would then do exactly the same work they do now, passing on the payments they collect from the reworked mortgages to the securities’ owners in each pool. The servicers would also foreclose on those properties the trustees had decided did not qualify for reworking. For performing those tasks, the servicers would continue to receive the fees due under their existing contracts.

We need an innovative approach to overcome the gridlock that plagues our housing markets. Otherwise, we imperil millions of homeowners and — through the alchemy of derivatives — the American and global economy.

I think their solution to the problems of falling home prices, abandonment and foreclosure is very interesting. It adds to previous suggestions.

News reports have indicated that the Bush Administration will unveil their plan shortly. We’ll see what aspects of the various proposals they will recommend.

photo credit: TheTruthAbout…

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