The Credit Crisis: Taking the Long View

JURIST Contributing Editor Douglas Branson, holder of the the W. Edward Sell Chair in Business Law at the University of Pittsburgh School of Law, offers a 50-year perspective on the structural roots of the current financial crisis in the United States and what factors ultimately helped to bring it about...

Harking back to the days of Ozzie and Harriet (the 1950s), mom and dad, or grandparents, made their mortgage application to the neighborhood savings and loan (Friendly). Commercial banks did very little mortgage business in those days. Mom and Dad filled out Friendly's loan application on Friendly's own form, at least to the point at which the loan officer said "that's enough, just sign it at the bottom." The loan officer also might say, "we don't need verification of employment. Everybody knows where you work, Joe (or Josephine)." He might add: "we don't need an appraisal. You just had one a year ago."

Friendly. Casual. One shortcoming was that if Friendly had $10 million to lend for 30 year mortgages, once it had used that amount up, Friendly could make no further loans. It lacked liquidity. Another shortcoming was that most home loans were conventional mortgages which required the purchaser to pay 20% of the agreed price, in cash at closing (downpayment). There were a few exceptions, such as Veterans' Administration (VA) and Federal Housing Administration (FHA) home loans, which called for lower downpayments but had limited eligibility and made the borrower jump through a number of additional hoops (get a home inspection, etc.).

Friendly's lack of liquidity is not quite as bad as it sounds. The average mortgage has a life of only 13 years. The mortgagor (homeowner) pays off their home loan because they are downsizing, moving to a larger home, or moving to a different neighborhood or city. Nonetheless, in the old days, lenders like Friendly had illiquid, stay-at-home loan portfolios.

Fast forward to the 1970s. A innovation arrived on the scene. Mortgage companies and savings and loans like Friendly could, at least if they were large enough, package a group of loans, selling the package to, say, an institutional investor such as an insurance company or a pension plan. If Friendly, now grown larger, packaged up $100 million in home loans, it would sell a "passthrough" $100 million package to, say, North Pacific Life Insurance ( Spokane, Washington) or the Hawaiian Structural Ironworkers Pension Plan (in Honolulu). Home owner would still pay principal, interest, and possibly escrow payments (for taxes and insurance) to Friendly. Homeowner would never know that Friendly no longer had her loan.

Friendly would deduct a one half percentage point service fee from the homeowner's payment, "passing through" the rest of the payment to North Pacific Life, who now owed the loan but remained behind the scenes. From Friendly's standpoint, it still made money on loan application fees (2-3 "points") and on service fees on loans it had sold. Most importantly, it's liquidity had been refreshed. Friendly once again had $100 million with which to make loans.

Some drawbacks: big chunks (difficult to digest) and a lack of diversification. Only the largest players could purchase many of these "passthrough packages." Moreover, they were relatively undiversified. If Friendly were Chicago based, and the Chicago economy went sour, Pacific Life executives would at least lose sleep, or possibly worse.

Asset Securitization

Fast forward to the 1990s. Let's break up that package into more bite sized chunks. Many more persons and institutions could participate as purchasers. And the big boys, who could and did purchase the bigger passthrough packages, could now get diversification: some loan participations from Richmond, some from Birmingham, some from Portland (Maine or Oregon). How do we do this? By issuing asset-based (mortgage based) securities. Friendly sells a passthrough package to a wholesaler, such as Ginnie Mae, Freddie Mac, or Fannie Mae, or to a private entity such as CountryWide or Home Gold. Some companies, such as Washington Mutual or Countrywide, were both retailers and wholesalers. Freddie Mac and Fannie Mae, contrary to what John McCain says, were quite small and did no retail business whatsoever (Freddie Mac, for example, has only 3,000 employees). In accordance with their Congressional mandates, they were purely wholesalers.

Freddie, Fannie, or another wholesaler would sell bonds to the public, using an implicit government guarantee (never express) to entice investors to purchase the bonds. Fannie Mae and Freddie Mac "step bonds," contractually required to re-adjust based upon inflation, were very popular, especially with retired persons. With the money they had thus borrowed, Freddie and Fannie purchased big passels of mortgages from retailers around the country.

Freddie or Fannie could do one of 3 things with the mortgage loans they purchased (Freddie and Fannie purchased 50% of the mortgages in this country, close to $2 trillion per year). One, they could keep them. Toward the end, they kept more and more of these mortgages in their "retained portfolio" (40% at Freddie Mac). Two, they could sell them as a passthrough package to a institutional investors, as above.

Or, three, they could securitize them. Freddie forms a special purpose entity (trusts, corporations, or limited liability companies - all were all used as SPE's). It puts "offshore" (into the SPE) $100 million in mortgages. The SPE, which is supposed to have 3% independent capital (later 10%) and independent governance, then holds the mortgages, selling securities (almost always interest bearing debt securities) to financial companies, institutional investors, and high net worth individuals. These were the securities Bear Stearns, Merrill Lynch, Lehman Brothers, Morgan Stanley, and J.P. Morgan, to name a few, purchased to the tune of hundreds of billions of dollars each. The SPE then passes on interest and principal payments to the securities holders, as the SPE receives them and deducts its costs (minimal).

Asset securitization grew from a few hundreds of millions early in the 1990s to several trillion dollars per year. Every kind of loan, or cash flow, began to be securitized: home improvement loans, student loans, boat loans, car and truck rentals, Mastercharge, Visa receivables, streams of box office receipts for new movies, and so on. Collateralized debt obligations (CDOs) achieved even greater diversification by packaging a mix (mortgage loans and truck rental receipts, for example).

Often the originator had to add a "credit enhancement" to make the "paper" more saleable. The originator might have to retain a residual (liability for the first $3 million in defaults); purchase insurance to cover at least some of the defaults (if defaults there were - a remote possibility); or purchase insurance which was not called insurance, and hence did not require maintenance of legal reserves by the issuer ("credit default swaps" - AIG was a big issuer) which states would require of a true insurance company.

Culprit Number One: Easy Money Up Front

So what is the picture here? The financial world is creating a system through which 20 or 30 times the volume may flow. Up front, at the consumer level, credit becomes easier and easier. Retailers, say, California saving & loans, abandon standards all together. The knowledge that they can wholesale anything out the back door means that they will let almost anything come in the front door. They approve loans for people without jobs, mini-mansions for persons who could only afford a house trailer or a modest bungalow, exaggerated and inflated incomes for persons with modest incomes, and adjustable rate mortgages with "teaser" upfront rates which attract people who will be in the zone of default the first time the interest rate adjusts upwards. Downpayments were 5% of the asking price, or downpayment requirements were evaded altogether.

Where were Freddie Mac and Fannie Mae? In Tuesday's presidential debate, John McCain put much of the blame on Freddie Mac and Fannie Mae. He stated that the credit crisis began with Fannie and Freddie's troubles. Wait a minute! Let's back up.

Freddie and Fannie lent discipline to the mortgage industry. Their forms and processes furnished the backbone for the industry. Now every loan applicant had to fill out Fannie's or Freddie's application form, verification of employment, get an appraisal, etc. As much as possible, every loan now had to be like every other loan, because the retailer would in all probability package up the loans and wholesale the package. No more ad hoc transactions as in the old days at Friendly were allowed anymore. The increase in liquidity and the standardization of loan backbones fostered by Fannie Mae and Freddie Mac saved consumers billions of dollars (trillions?) and put millions of Americans into homes.

Rogue retailers, however, learned to game the system. They completed loan packages for homeowers by instructing or tolerating the rogue lender's employees filling in many of the blanks themselves, exaggerating or making it up. They sometimes made mockeries of the backbones Freddie Mac and Fannie Mae had imposed upon the industry. Was it Fannie Mae's and Freddie Mac's role to police and discipline this? No, not as Congress set them up. Freddie and Fannie were to be wholesalers, not retailers or "mortgage companies," as politicians, newspapers and editorial columnists report. Yes, as politicans and irate news columnists view the past with 20-20 hindsight: Fannie and Freddie should have acted as police officers.

Freddie and Fannie were also hampered by their congressional mandated governance. A third or so of their directors had to be political appointees or representatives of the home building industry. Many of these directors (ex senators, former lobbyists) complained when Freddie Mac asked them even to page through 15 page board packet prior to a meeting. President Bush's appointments to these boards were wholly political and without substance, as probably were his predecessor's as well.

Now come the richest of the rich: the financial service firms. On Sixty Minutes on Sunday night, the interviewer asked why these companies had purchased so much of "these risky securities." The problem was in fact just the opposite. These securities appeared to carry very little or virtually no risk at all. Homeowners pay their mortgage and their electricity bills before any other. The default rate on mortgages is less than one-tenth of one percent. Even in the midst of a "mortgage crisis," the default rate is only 3% and likely not to increase much past 4% unless the mortgages drop seriously "under water."

The safety of these securities caused financial firms to load upon on them ("back up the truck," in Wall Street parlance). They were considered so safe that financial firms used borrowed funds to buy more, and more, and more.

Culprit Number Two: Greed on Wall Street

Easy money up front was the first culprit. Easy money on the back end was the second. Leverage we call it.

The average industrial or service firm borrows money but in moderation. The average across all corporations is about 60% or 65% of equity. Thus, if owners put in $10 million (equity), they layer another $6 million in bank loans on top of that. Some companies which have steady cash flows (electric utilities, phone companies) may have more leverage. Ratios of 3 to 1 or even 5 to 1 are not unusual. Financial experts, however, are wary of leverage, or of too much leverage. Leverage makes good years better but it also can work in reverse, making bad years much worse.

At Bear Stearns the debt equity ratio was 34. Lehman Brothers' ratio was 32. Merrill Lynch's was 31. Morgan Stanley's was 26. At Fannie Mae and Freddie Mac it was a more reasonable but still immodest 20 to 1.

These were conservative securities, say, paying 6% or 6.5%. But purchasers could borrow from banks, paying 3% or 3.5% interest for funds with which they could purchase these safe securities. And they did borrow, more and more and more, to purchase asset backed securities. Bear Stearns put in $10 billion of its own capital but borrowed $340 billion additional dollars. It thus stood to make over a 100% profit on invested capital, that is, as long as the spread stayed positive. When the increasing default rate made the spread appear to be heading for the negative, the value of the securities fell.

Thus, both on the front end, and on the back end, the tale is one of unbridled greed: rapacious homeowners and savings and loan officials and equally at fault Wall Street CEOs and other executives.

Culprit Number Three: Excessive Accounting Conservatism

Now enter the third player (not culprit really): the accounting rules. When an individual or a company holds assets on their balance sheet, they hold them at cost. Cost in this instance would be approximately the same as the face value of the securities, adjusted for ups or downs in prevailing interest rates. When the assets are investment securities, however, the accounting rules are different. The holder must sort them into piles, such as "hold to maturity," which it can continue to carry at cost. Or, "available for sale," which it must "mark to market." As greater default rates loomed on the horizon, Wall Street firm had to mark down, and down again and again, the carrying value of these mortgage backed securities, CDOs, etc., because all, or nearly all, fell in the "available for sale" category. The balance sheet writedowns created floods of red ink which flowed over onto firms' income, or profit and loss, statements. Suddenly bedrock financial firms had huge losses. Losses triggered defaults on loans the firms have taken out. The red ink chased the firms into the arms of other more solvent firms, or into bankruptcy.

It is these marked down securities which the U.S. proposes to buy with the $700 billion "bailout." Is this relieving Wall Street fat cats from the responsibility and the pain for their own greed?. You can look at that way but the firms which have failed still have positive cash flows. It is paper (accounting losses) which did them in in the end. The mid course correction is cleaning up balance sheets which were badly distorted by writedowns that did not jive with reality.

Another way to look at it is as a necessary first step to get our economy back on a middling course. We veered far too much toward the permissive before Enron, WorldCom, Adelphia and other accounting and governance imbroglios stopped us in our tracks. Then the pendulum swung but, as it always the case, it swung too far over in the other direction. For one, we became awash in a seas of accounting conservatism.

Under this view, the governmental action is not, strictly speaking, a bailout. The government will be an astute buyer of these securities, paying on the order of 20 or 30 cents per dollar of face value. Most of these securities (95%) will purr along, paying interest at the stated rate. And as the homeowners pay off the mortgages, the government will receive 90 or 95 cents on the dollar for securities purchased at a fraction of that. No less an astute investor than Warren Buffett has said he would buy up these securities if he had the fund available.

The Bailout

So is it a bailout? Yes, it is a bailout of some highly compensated Wall Street executives who will avoid the full consequences of their own greed. Is it a deadweight loss for the taxpayers? No, the US could even make a handsome profit (but no guarantees) on its $700 billion investment. Could the money be better spent distributing it to homeowners who cannot make their mortgage payments, as more than several politicians have suggested? That is a value judgment each of can make but, as currently structured, the government has a better than even chance of getting its money back and then some. Or at least it does if real estate price stabilize. (If many, many more mortgage balances fall below probable market value ("under water"), homeowners will abandon homes, and mortgages in increasing numbers and default rates will rise, perhaps to an unacceptable level. But that's another problem).

On the other hand, payments to homeowners to help them catch up would represent a sunk cost, and a deadweight loss to the U.S. Treasury. And it is a bailout of sorts as well. Many of the persons on the verge of defaulting on home loans knowingly over-extended themselves, misrepresenting their income or purchasing much more house than the could realistically afford.

Douglas M. Branson holds the W. Edward Sell Chair in Business Law at the University of Pittsburgh and is the author of Corporate Governance (1993). His newest book, No Seat at the Table, about the dearth of women directors in the Fortune 500, will be published by NYU Press in December.

Opinions expressed in JURIST Commentary are the sole responsibility of the author and do not necessarily reflect the views of JURIST's editors, staff, donors or the University of Pittsburgh.

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