I recently attempted to explain to my graduate finance students exactly what happened to companies like Lehman and AIG. I realized that the explanation was so complex that even my students were having difficulty understanding the ins and outs of the problem as well as the implications of a potential bailout. I am going to attempt to explain this as simply as possible.
Years ago it occurred to analysts that banks would be able to lend more money to homebuyers if they didn’t have to hold the loans in-house. Typically, the bank would lend the home buyer the money and the bank would hold the deed to the home in the event that the home buyer defaulted on his mortgage payments. What analysts did was to structure a conduit for those banks to sell the loans in order to secure more funds to make more loans. For example, if a bank had $1,000 to lend and had to keep only $30 in reserve to back what had been lent, if the bank could sell that loan and get its money back it could lend another $970 ($1,000 - $30). The bank could charge the homeowner 5%, sell $970 in loan to someone else who would get 4.75%, and the bank would be able to “skim” 0.25% as profit.
The purchaser of the loan didn’t just buy one loan; it bought hundreds or thousands of loans that had been “pooled” together in order to reduce the risk of one or two loans going bust. Why would there be any more or less risk associated with any particular pool of mortgages? Because not all borrowers are the same; some are considered to be more or less willing and/or able to pay the interest and principal on their mortgage on a timely basis, thus assuring that the poll would always have sufficient funds to pay interest and principal to the purchaser of the pool. In the event that any particular homeowner was unable to make interest and principal payments, thus defaulting on the loan, the pool still had the deed associated with that mortgage and could always sell the home if necessary. The pool would normally be broken down into bonds with denominations of $1,000 each and sold to the public. The pool would consist of more mortgages than were necessary to break even at the end of every month; the pool might actually bring in $100,500 dollars in interest and principal and pay out only $1,000 to the bondholders, giving the pool a “cushion” of $500 in case some of the homeowners were unable to make their payment that month. The pool would be “overcollateralized”, or have more collateral than the total amount of the bonds issued, in order to assure that, in the event that the homeowners were unable to pay their mortgages and the homes were repossessed and the homes were not worth what they had been appraised for by the original lender, there would be enough collateral in the pool to liquidate it, if necessary, and get back enough money to pay off the principal on the bonds.
In order to determine how much to overcollateralize the pool, the pool’s underwriter used a worst case scenario, usually the worst year of the Great Depression, to analyze how much stress the portfolio of mortgage loans could withstand in the event that the economy tanked and homeowners began defaulting at alarming rates. So, depending on the credit ratings of the individual home purchasers, pools would be established that required different amounts of overcollateralization, depending on that pool’s ability to withstand a downturn in the economy.
The home owner who borrowed the money initially to purchase that home had a credit rating which gave the lender, usually a bank or mortgage company, some indication of the amount of risk that borrower posed. The amount of interest the purchaser would demand was dependent upon the riskiness of the pool that was being purchased. The purchaser might, for example, be willing to accept 4.75% for some pools and require 4.85% for others that were more risky. Bond insurers, such as MBIA and FGIC, would review, or were supposed to review, the borrowers’ ability to pay interest and principal on time in order to assure that the risk of the pool was accurately represented to them by the seller prior to insuring these pools. Analysts would do this by choosing individual loans at random, say one out of a hundred in that pool, and make sure that the borrower indeed had the criteria required to for his/her mortgage to be a part of that pool. The bond insurance would give the pool whatever bond rating the insurer had. So, if a pool actually represented the amount of risk associated with a BBB rating, the bond insurer would charge a premium to assure to investors that the interest and principal on the pool would be paid on a timely basis. The bonds would then assume the same rating as the bond insurer, usually a AAA rating.
These pools would be broken down into $1,000 pieces and sold as bonds to investors. Most “ma and pa” investors purchased the insured bonds. Savvy investors, such as Lehman, purchased uninsured bonds. Lehman’s analysts had an obligation to review the pools to see if the risk of holding these bonds was indeed that which was represented to them by the seller of the bonds, usually an investment bank that had put the pool together and underwritten it in the first place. Companies like Fannie Mae and Connie Mac also purchased these pools and issued bonds themselves.
The above, with minor variations in some cases, is the typical structure of what is known as a Collateralized Mortgage Obligations. Other collateralized pools came into existence once the formula proved to be successful, such as pools backed by automobile and credit card receivables. The generic acronym used to describe this market segment is CDO, short for collateralized debt obligation.
What Went Wrong?
The structure worked well with fixed rate mortgages. There was certainty in the structure in that the credit rating of the borrower was relatively stable over time and the payment didn’t change, unless the real estate tax, which is included in most mortgage payments, increased.
New types of mortgages were being offered; ones whose payments started off low and were “reset” at a higher rate at some time in the future. The lower rate was commonly referred to as a “teaser” rate because it drew in borrowers who might not qualify for the loan had it been offered at the higher rate to which it might be reset, thus enticing them into purchasing homes thinking that they would be able to afford the increased mortgage rate at the time of the reset. The thinking on the part of the lenders was that if the borrower defaulted on the loan, and the lender had to repossess the home, there would be enough equity in the home to make the lender whole upon sale of the home. In addition, the interval between the time the loan was granted and the time it would reset was considered sufficient for the average borrower to increase his/her income to a level that would enable that borrower to afford the increased mortgage payment. The reset rate would usually be “pegged’ to some standard rate such as the prime rate.
However, what would happen if the borrower’s income did not rise enough to afford the reset rate? Or what if the standard to which the reset rate was pegged rose to a level which made it impossible for the borrower to make mortgage payments? Common thinking was that the home could be repossessed and be sold for enough to satisfy the amount owed on the home; any overage would be returned to the borrower. But what would happen if the home could not be sold for an amount in excess of the amount of the loan, or worse, for a great deal less than the amount of the loan? The bank had two options: either sell the home for less and take a loss or hold on to the home until the real estate market improved and the home could be sold for the amount of the loan.
A combination of unfortunate events occurred at the same time. The economy began to show signs of weakness. Salary increases declined, and many times employees received no increase at all. Unemployment began to rise. The real estate market began to tank. This was a deadly combination for the average homeowner. Homeowners found that they could not afford to pay the higher reset rates. Default rates on mortgages began to rise. The “cushion” that had been built into these mortgage pools was insufficient to account for all the defaults. Homes were being repossessed at alarming rates. Mortgage holders ended up with deeds to property that could not be sold for the amount of the outstanding debt. The stream of payments from the remaining borrowers plus the amounts recouped by the sale of homes now owned by the pools was insufficient to pay the interest and principal to the holders of the bonds backed by these pools. The bonds were in jeopardy of default, if they had not already defaulted.
The “ma and pa” investors were usually protected by bond insurance and continued to receive interest and principal payments on time. Unfortunately for the bond insurers, the rate of default was greater than they anticipated and put a strain on their capital reserves, or the amount of cash they were required to hold in the event that they needed funds to pay claims. What made things worse was that the bond insurers stopped insuring these bonds and lost an important source of premium revenues: it was a double-whammy! Not only that, but the bond rating agencies downgraded these insurers and they became unable to offer the AAA ratings to potential debt issuers. If they couldn’t offer a AAA rating, they would not be able to charge the higher premium associated with that rating and this squeezed their revenue stream as well. They were forced to either accept greater risk and insure more risky debt, or stop insuring bonds completely, thus choking off their most important source of revenues. Basically, they were out of business! Ma and pa were worried that their bonds might default and there would be no insurance to make sure that the check would be in the mail every six months.
What was worse, however, was that all those uninsured bonds held by savvy institutions might go south as well. Even if they didn’t, market conditions being what they were, drove the prices of these bonds lower as investors demanded higher interest rates for taking on similar risk. These institutions are required to “mark-to-market” at the end of each quarter, which means that they have to determine the market value of their financial holdings and adjust their balance sheets accordingly. As the value of these bonds declined, so did the amount of capital on their balance sheets. So not only were they holding bonds that were close to default, if they hadn’t already defaulted, but they were also forced to adjust their balance sheets thus reducing the value of their companies and the stock they had issued. Suddenly, the value of their stocks declined and created waves throughout the securities markets.
What Was the Government’s Solution?
Then the government stepped in. Did they cure the situation? No! What they did was assure investors that their stock holding of these companies would not be worthless by stating that the government would purchase the bonds issued by these corporate giants, thus preventing them from Chapter 11 filings (reorganization). Government sources estimated that this would cost upwards of a trillion dollars. Where would the government come up with an additional trillion dollars? By issuing more treasuries! What would be the mechanism for such a move? A government agency similar to the Resolution Trust Corporation that had been employed about 20 years ago to deal with the savings and loan crisis, in which John McCain and Neil Bush (our current president’s brother) had been involved.
Savvy investors understood what this meant, but Ma and Pa had no idea. So the government blamed the Securities Exchange Commission (SEC) for lax rules and a lack of supervision. Of course this was total nonsense. Presidential candidate John McCain went so far as to say that his solution would be to fire the SEC chairman. Then restrictions were placed on “naked” short selling, or selling stock that an investor did not yet own, which did virtually nothing for the markets but create even more confusion. The idea was to prop up stock prices by limiting the ability for funds and individuals to “hedge” their long positions on volatile equity securities. The stock market came back to what it had been before all this happened, but this still did not solve the problem. Since the only way anyone could sell short was to actually own the securities that had been sold short, holders of volatile securities had two choices; either to sell their positions into a declining market and take losses or purchase the actual stocks in which they held naked positions.
What the government proposed was to purchase the actual assets along with the virtually worthless bonds from holders of these CDOs and sell the properties and homes when the real estate market recovers.
Why Does This Scheme Create Problems?
This solution has some big problems that most people do not anticipate.
The first problem is the issuance of another trillion in treasuries. These will assumedly be long-term treasuries in order to match the period of time the problem may continue. It will most likely take at least 8 years (depending on what this does to the natural cycle of real estate pricing) for the real estate market to recover somewhat from the doldrums it in now in. As these properties are sold into a slowly recovering real estate market, assuming there is a recovery, the sale of these properties will create more supply of properties and suppress prices. This assures that whatever recovery in prices might take place; it will take much longer to return to levels that had been reached prior to the decline in the market. In fact, it might take much longer than anyone anticipates depending on the amount of assets that the government wells back into the market and the timing of these sales.
The second problem is the continuing issuance of treasuries. This creates a problem in that it the dollar weakens as more treasuries are auctioned. This is a simple supply and demand curve; the more supply there is, the less the price (and the higher the interest rate) purchasers are willing to pay, given that demand remains the same. In that treasuries are auctioned and not tied to a fixed commodity with a fixed price, like they were years ago (that commodity being gold) when demand meets supply, the price is determined. The dollar weakens as a result of its value vis a vis other currencies that are not issuing such large amounts of securities. This could ultimately lead to massive inflation as demand for the dollar declines and it costs more to purchase products overseas. In addition, more dollars overseas will most likely lead to overseas investors seeking hard assets, usually real estate, because they do not want to hold dollars as their value declines.
The third problem is the continuing decline of the economy. As existing housing is sold back into the market at what most likely will be bargain basement prices, the demand for new housing will decline precipitously. As most economists know, new housing is what drives our economy. The reason for this is that there is a tremendous amount of material, including building products such as concrete, furnishings which include carpeting and furniture among other things, and appliances. Much of these are manufactured in the United States. As demand for these weakens, companies that manufacture such products will consolidate, if not close up entirely, and people will lose their jobs. A loss in jobs will exacerbate the problem in that there will be even more mortgage defaults. Until the dollar weakens to the point that products manufactured in the US are cheaper to buy overseas than they are currently, manufacturing will not return and high paying jobs that enable workers to afford homes will not be created. It is doubtful that this will happen in that labor in places like china and Malaysia are so low that there is no reason for companies to locate facilities in the US. (Fixed costs, such as bricks and mortar for factories remain pretty much constant throughout the world; virtually the only variable cost is labor.)
What is the Solution?
The real solution is to allow the market to self-correct. The more government intervention, the worse the problem becomes in the long run. By the government purchasing distressed properties and “adding liquidity” to the system, real estate will not decline in value to the point where demand returns and prices go up, thus creating value and wealth for those with the cash and foresight to purchase it at what are now considered bargain basement prices. Much of this buying would most likely come from overseas, returning dollars to the system and creating the same liquidity that the government is attempting to restore. The only difference is that instead of returning such liquidity to the banks, it would return that liquidity to Ma and Pa. Instead of making the wealthy investment bankers whole, it would ultimately make Ma and Pa whole. Certainly those who lose their jobs will suffer as a result of the artificial nature past practices and the ignorance of those investment bankers who believed that real estate values would go up forever. However, without such a correction our system does not work efficiently. What is ultimately created by such intervention is some form of socialism in the reverse. It creates a system that drains resources from the middle class, the only portion of the population that can afford to pay higher taxes that will be used to pay interest on the treasuries that will be issued in order to fund this scheme, and gives these resources to the investment bankers and those who hold the stocks of these investment banks. Draining the middle class of disposable cash necessarily suppresses their ability to purchase products and further exacerbates an already difficult problem. If this government solution occurs, which looks like a certainty, there will be more jobs lost throughout the economy, albeit investment bankers will remain employed and continue to create these kinds of financial products and take the same risks as they have in the past. There are no restrictions being placed on the banks in terms of what kinds of products they may create.
So the solution is for the government to do as little as possible for the investment banks and insurance companies and as much as possible for the homeowners who cannot pay their mortgages. Only thus may our government actually create some certainty that the self-correction will be somewhat orderly and timely. This might be in the form of mortgage insurance that the individual homeowners pay when a loan is granted. There might be other solutions, however those solutions must not be on the backs of taxpayers and must remain within the realm of real estate owners. It is the homeowners who take the risk; it is the homeowners who must bear the brunt of the correction.
Mr. Howard Kupferman is an adjunct professor at Polytechnic Institute of NYU.