Tag Archives: Securitization

Fannie and Freddie’s Confused Futures

By William K. Black

(cross-posted with Benzinga.com)

A few days after the Obama administration released its vague concepts for the future of Fannie and Freddie it issued budget estimates for Fannie and Freddie’s losses premised on the continued existence, indeed, expansion of Fannie and Freddie. The administration assumed that the cost of resolving Fannie and Freddie would drop by roughly one-half – by 2021. The predicted reduction in losses appears to come not from improvement in Fannie and Freddie’s bad assets, but rather from profits on Fannie and Freddie’s overall operations. These profits stem from Fannie and Freddie, which are now publicly-owned, being able to borrow funds at or near the governmental rate. That price advantage makes it impossible for any private entity to compete with them in the secondary market. This purported reduction in the cost to the public of resolving Fannie and Freddie’s failures is not really an economic savings – unless one ignores the implicit cost of issuing government debt to fund Fannie and Freddie. The nominal accounting savings, however, will be exceptionally attractive to politicians. Administration officials will have an overpowering desire to claim that their brilliance cut Fannie and Freddie’s costs in half. Collectively, this will provide powerful incentives to continue Fannie and Freddie as a huge governmental enterprise.
We need to understand why Fannie and Freddie became massively insolvent. It wasn’t because they were governmental, but because they were private. It is simple to run Fannie and Freddie in a safe and sound fashion. Fannie created the concept of prime loans and prime loans have exceptionally low credit risk. Fannie and Freddie can easily spot any degradation in credit quality by reviewing samples of the loans insisting on full underwriting. Fannie and Freddie can minimize interest rate risk by creating and selling MBS and hedging the pipeline risk. When Fannie and Freddie were governmental 25 years ago they did not deliberately take excessive risks. They did not understand how to hedge in a fully effective fashion, but we have learned a great deal in 25 years about how to hedge pipeline risk.

The risks to Fannie and Freddie are governmental, not financial. The government could decide to do extremely destructive things to Fannie and Freddie.

The risks to a privatized Fannie and Freddie (by whatever name) are even greater. If the existing systemically dangerous institutions (SDIs) became private label securitizers they would have all the perverse risks that come from modern executive compensation. They would pose a systemic risk if they were to fail – which is why regardless of how much the government promised not to bail them out no one would believe it. That is why they would be GSEs regardless of their official designation. The more they are perceived as GSEs the greater the political risk that Congress will demand dangerous actions from the private label securitizers.

It is not clear why the administration believes that securitization of mortgages is necessary or even desirable. Portfolio home lenders will face prepayment and interest rate risk, but those risks are simply transferred, not removed, by securitization. Given what we have learned from the crisis, the assumption that securitization leads to an efficient distribution appears baseless. Some banks will doubtless fail if interest rates increase sharply and remain high for many months, but hedging and macroeconomic policy can greatly reduce the failure rate among banks.

The first step, however, should be to make the existing disaster that is Fannie and Freddie fully transparent. We need to investigate fully what went wrong. If Fannie and Freddie put all their information on the web we could bring the wisdom of the masses to bear and determine the truth. There is no reason why Fannie and Freddie should have broad proprietary secrets.

Selling Death: Wall Street’s Newest Bubble

When Wall Street’s commodities bubble crashed last year, I asked whether the next bubble might be in securitized body parts. Wall Street would search the world for transplantable organs, holding them in cold storage as collateral against securities sold to managed money such as pension funds. Of course, it was meant to be an apocryphal story about unregulated banksters gone wild. But as the NYT reports, Wall Street really is moving forward to market bets on death. The banksters would purchase life insurance policies, pool and tranch them, and sell securities that allow money managers to bet that the underlying “collateral” (human beings) will die an untimely death. You can’t make this stuff up.

This is just the latest Wall Street scheme to profit on death, of course. It has been marketing credit default swaps that allow one to bet on the death of firms, cities, and even nations. And the commodities futures speculation pushed by Goldman caused starvation and death around the globe when the prices of agricultural products exploded (along with the price of gasoline) between 2004 and 2008. But now Goldman will directly cash-in on death.

Here is how it works. Goldman will package a bunch of life insurance policies of individuals with an alphabet soup of diseases: AIDS, leukemia, lung cancer, heart disease, breast cancer, diabetes, and Alzheimer’s. The idea is to diversify across diseases to protect “investors” from the horror that a cure might be found for one or more afflictions–prolonging life and reducing profits. These policies are the collateral behind securities graded by those same ratings agencies that thought subprime mortgages should be as safe as US Treasuries. Investors purchase the securities, paying fees to Wall Street originators. The underlying collateralized humans receive a single pay-out. Securities holders pay the life insurance premiums until the “collateral” dies, at which point they receive the death benefits. Naturally, managed money hopes death comes sooner rather than later.

Moral hazards abound. There is a fundamental reason why you are not permitted to take out fire insurance on your neighbor’s house: you would have a strong interest in seeing that house burn. If you held a life insurance policy on him, you probably would not warn him about the loose lug nuts on his Volvo. Heck, if you lost your job and you were sufficiently ethically challenged, you might even loosen them yourself.

Imagine the hit to portfolios of securitized death if universal health care were to make it through Congress. Or the efforts by Wall Street to keep new miracle drugs off the market if they were capable of extending life of human collateral. Who knows, perhaps the bankster’s next investment product will be gansters in the business of guaranteeing lifespans do not exceed actuarially-based estimates.

If you think all of this is far-fetched, you have not been paying attention. From Charles Keating’s admonition to his sales staff that the weak, meek and ignorant elderly widows always make good targets, to recent internal emails boasting about giving high risk ratings to toxic securities, we know that Wall Street’s contempt for the rest of us knows no bounds. Those hedge funds holding CDS “insurance” fought to force the US auto industry into bankruptcy for the simple reason that they would make more from its death than from its resurrection. And the reason that most troubled mortgages cannot obtain relief is because the firms that service the mortgages gain more from foreclosure. It is not a big step for Wall Street and global money managers with big gambling stakes at risk to slow efforts to improve health. Indeed, it is easy to see some very nice and profitable synergies developing between Wall Street sellers of death and health insurers opposed to universal, single-payer health care. As AFL-CIO Secretary Treasurer Trumka recently remarked on NPR, we already have committees deciding when to cut-off care—the private health insurers decide when to deny coverage. It would not be in the interest of securities holders or health insurers to provide expensive care that would prolong the life of human collateral—a natural synergy that someone will notice.

It should be amply evident that Wall Street intends to recreate the conditions that existed in 2005. Virtually every element that created the real estate, commodities, and CDS bubbles will be replicated in the securitization of life insurance policies. If Wall Street succeeds in this scheme, it will probably bankrupt the life insurance companies (premiums are set on the assumption that many policyholders will cancel long before death—but once securitized, the premiums will be paid so that benefits can be collected). But it is likely that the bubble will be popped long before that happens, at which point Wall Street will look for the next opportunity. Securitized pharmaceuticals? Body parts?

Here’s the problem. There is still—even after massive losses in this crisis—far too much managed money chasing far too few returns. And there are far too many “rocket scientists” looking for the next newest and bestest financial product. Each new product brings a rush of funds that narrows returns; this then spurs rising leverage ratios using borrowed funds to make up for low spreads by increasing volume; this causes risk to rise far too high to be covered by the returns. Eventually, lenders and managed money try to get out, but de-levering creates a liquidity crisis as asset prices plunge. Resulting losses are socialized as government bails-out the banksters. Repeat as often as necessary.

Reform of the US financial sector is neither possible nor would it ever be sufficient. As any student of horror films knows, you cannot reform vampires or zombies. They must be killed (stakes through the hearts of Wall Street’s vampires, bullets to the heads of zombie banks). In other words, the financial system must be downsized.

Time to Foreclose the Mortgage Companies

One thing that puzzles many people is how on earth could a relatively small problem with subprime mortgage loans in America have generated a global financial and economic calamity that is already (arguably) rivaling the Great Depression of the 1930s. After all, the total residential mortgage backed securities universe was only $7.1 trillion at its peak, of which just $1.3 trillion were subprimes. Other asset-backed securities were $2.5 trillion, with home equity loans amounting to $600 billion of that. Yes these are big numbers, but US home values were worth $20 trillion. If real estate prices fell by 30%, values would still be worth twice as much as the securities based on homes. And even if defaults reached 50% on subprime loans, it would appear that losses on the securities that used them as collateral could not amount to much more than a hill of beans ($650 billion of defaults, of which 70% is recovered through sale of the home generates losses of less than half a trillion). Even if we add losses on Alt A’s and prime mortgages, plus home equity loans, how could banks have already lost many trillions of dollars, requiring a federal government commitment of $23 trillion to try to resolve the crisis?

Here are three answers offered in partial explanation:

1. In the right conditions, a relatively small perturbation can generate huge fluctuations—like the flapping of a butterfly’s wings in India that creates a tornado in Kansas. Many point to the 1929 stock market crash as the trigger that began the Great Depression because speculators had to meet margin calls, thus, began to sell assets and default on liabilities. Yet, as John Kenneth Galbraith argues in his “The Great Crash”, the total number of players in that stock market boom could not have been a million people. It was the fragile condition of the entire financial system (and of the economy itself, in part due to a grossly unequal distribution of income) that allowed the crash to trigger a depression. As Hyman Minsky argued, over the entire postwar period, the US and even the Global financial system were evolving toward fragility, making “it” (another great debt deflation) possible. The trigger happened to be subprimes, but there were any number of other possibilities waiting to happen. Add onto that a distribution of income that is as bad as it was in 1929 and you have a recipe for disaster.

2. That leads to the second point: the problem was not just with subprimes. All kinds of debts—including those associated with other kinds of mortgages, with commercial real estate, with credit cards, with auto finance, with small business loans, and so on—were structured in a similar manner. To put it bluntly, much of the finance was “Ponzi”—pyramid schemes that make Bernie Madoff look like a piker. As soon as asset prices stopped rising, the pyramid collapsed—so the losses are across all asset classes, and all over the globe.

3. The same financial institutions that created this mess are preventing resolution because it is far more profitable for them to ride out the collapse. They made money hand over fist on the way up, and plan to continue to do so as they drive the economy to hell. Much of the profits are illusory or are provided by government handouts. But there is real money to be made squeezing debtors, as reported in today’s NYT.

Let me give just one example, based on that NYT article and some research done by UBS (UBS Investment Research. 2007. “Investment Strategist” Digital newsletter, November 27). Keep in mind that when we destroyed the thrifts in the 1980s, we transitioned to a new “market-based” home finance model that involves independent mortgage brokers, property appraisers, risk raters, title companies, mortgage insurers, credit default swap sellers, mortgage servicers, securitizers, accounting firms, commercial banks, investment banks, and pension funds and other managed money that hold the securities. In this “originate to distribute” model, almost all concerned live on fee income rather than on the interest and principal payments of homeowners (which service the securities). Of course, this is part of the reason that no one ever bothered to check whether the homeowner would actually be able to make the mortgage payments.

It is also the reason that almost no one in the home finance food chain cares about resolving the home mortgage crisis—it is far more profitable to most concerned parties if the homeowner cannot and does not make any payment. When the homeowner stops making payments, the mortgage company that services the loan makes the payments that are then distributed to the securities holders. In return, the mortgage company collects its normal servicing fee, plus late fees of 6% of the monthly payment. As the NYT reports, these late fees alone can amount to 12% of the total revenue received by loan servicers. (Of course, it is no different in the video rental business or in the credit card business—better late than on time!) It is in the interest of the mortgage companies to maximize the number of delinquencies as well as the amount of time each household is delinquent.

When a house is finally foreclosed, the mortgage servicer has first dibs on the revenue from sale of the house. According to the UBS study, foreclosure can take up to two years (depending on the state and on complications) and total costs—including paying off the servicer—can eat up 90% of the revenue from the home sale. This is why the total losses on home mortgages (absorbed mostly by the securities holders) are so huge even if home values fall by “only” 30%.

As the NYT reports, these mortgage companies actively interfere to ensure that homeowners are not able to renegotiate terms of mortgages instead of going into foreclosure. They prefer a “purgatory—neither taking control of houses and selling them, nor modifying loans to give homeowners a break.” When the foreclosure proceeds, the mortgage companies not only accumulates late fees, but also pay for many other services– often to their own subsidiaries–such as title searches, insurance policies, appraisals, and legal findings. That is all recouped with the property sale. This explains why none of the government policies to date have been able to keep people in their homes by negotiating better mortgages. Indeed, even though the government is trying to bribe mortgage companies with $4000 to modify a loan, they make more money if they drive the owner out of the home. Ideally, they will accumulate claims on the house up to the total market value!

It is time to foreclose on the mortgage companies. As I have explained before, we ought to adopt the plan proposed by Warren Mosler and Dean Baker: allow people to stay in their homes, paying fair market rent. Put the homes through a simple and quick foreclosure with the government standing ready to buy the houses at either current market value or at the value of the outstanding mortgage (whichever is less). The former owners would then have first right of refusal to repurchase the home in two years, at market value and with good mortgage terms. We also need to get back to a more sensible home finance system, based on simple mortgages that are held to maturity by lenders, and with far fewer fees. That means shutting most players out of the home finance business.

A similar story can be told for other sectors, where parasitic financial market participants are making out like bandits (yesterday I discussed Black Rock’s new scheme to bilk investors by selling them the toxic waste Wall Street doesn’t want). Washington is facilitating this by contracting with the same firms that caused the crisis to deal with the fall-out. The longer and deeper the crisis, the more money there is to be made. As long as Wall Street runs government, do not expect resolution.

Fixing the Financial Crisis

James K. Galbraith, University of Texas economics professor, offers his insight.


Minsky and the Regulation of the Financial System

Click here to read Jan Kregel’s presentation at the 18th Annual Hyman P. Minsky Conference.

What Caused the Crisis?

Click here to read James K. Galbraith’s piece on the causes of the crisis.