The Financial Crisis White Paper

Introduction: For long term readers, you may find that this is a recap of many other things I wrote, however here is an in depth report of the crisis and the solutions.

Before beginning, I want to quote from this Wall Street Journal article last fall.

Is a housing bailout the solution for clogged-up credit markets and a faltering economy? What the Fed has been doing and did again yesterday hasn't really worked, notwithstanding the pops it produces in the stock market every time it shovels liquidity into the system. The Fed's latest move provides financial institutions another $200 billion in direct short-term lending against their unsaleable housing collateral. The Dow Jones jumped 416 points. But it won't restart markets for the underlying collateral.

Where are the speculators, vultures and hedge funds? Where are the big money players willing to buy the exotic but still substantial mortgage-backed securities for which markets have ceased? The Fed's liquidity rush seems only to have convinced them the time is ripe for staying on the sidelines.

To get to a real solution, speculators and investors need to believe that home prices are hitting bottom, that any mortgage debt they might buy today for 80 cents on the dollar today won't be worth 30 cents tomorrow. Then the vultures will pile in: The transfer of wealth from the overleveraged banks and hedge funds to those who kept cash handy will be shocking, ugly and cathartic -- but it will also be relatively quick. Credit markets will begin to function again. The economy will grow.”

To try and understand the current crisis, we first need to understand how we got here. First, we must go all the way back to the end of 1999. That’s when Alan Greenspan, then head of the Federal Reserve, first began raising the Prime Interest Rate. This move surprised most everyone, and Wall Street included. This led directly to the popping of the so called Internet bubble. This bubble popping cost roughly $3 trillion in paper losses in stocks between March and December of 2000. This led directly to the recession that awaited George Bush when he entered office in January of 2001.

The economic malaise that was materializing in late 2000 was only exacerbated by two other events, 9/11 and the revelations of Enron et al. As such, by the end of 2001, we were in a full blown recession. While President Bush was enacting tax cuts, Alan Greenspan was furiously reducing interest rates just as quickly as he raised them in 1999-2000.

By the end of 2002, Greenspan had lowered interest rates so aggressively that the Fed Funds Rate, the rate that banks borrow from each other at, stood at .75%. The Fed Funds Rate is an overnight rate. This is important to understand because there are only two reasons why a bank would borrow overnight 1) they’d done something reckless and needed the money or 2) they were about to do something reckless and need the money. Greenspan lowered the Fed Funds Rate below 1% for well over a year and kept it there.

What this did was create so called loose money. Banks had access to far too much easily available cash. The recession had depressed almost all industries at the time except one, real estate. That’s because the recession had also led directly to record low mortgage rates. We were at the time in the middle of what was dubbed the refinancing boom. Because interest rates work in relation to relative inflation, the recession was great for rates because at the time the only fear was deflation. The record low rates didn’t only create a lot of refinancing but also led to more buying. At the time, we were just seeing the beginning of the real estate boom.

Because real estate was the only good sector, all this extra available bank capital went into one place, mortgages. The ‘problem” if you will at the time was that banks had more money than available loans. The solution was the birth of the sub prime explosion. Because folks with good credit (prime borrowers) were limited, banks began looking to more non traditional places for their money.

Mortgage Backed Securities, which bundled these sub prime loans and turned them into bonds, were the brainchild originally of Lew Ranieri at Lehman Brothers in the 1980’s. The financial vehicle had its glory days in the late 1980’s and early 1990’s, but since then the vehicle had lost some favor. It was, however, ready for a resurgence. Banks came to hedge funds, insurance companies, private equity firms and other financial conglomerates with ideas for new and aggressive loans. Because real estate was starting to move, these securitizers (those that package these loans together and turn them into bond) were all too willing to create new Mortgage Backed Securities out of these more aggressive ideas.

For the first couple years, the industry moved aggressively to loosen guidelines, but these moves were still relatively tempered. That all changed in 2005 when a new sub prime player entered the market. That player was Argent Mortgage, the sister company of Ameriquest. Argent would be able to walk into just about any mortgage company and offer more aggressive loans than anyone else. This caused panic and frustration in all their competitors as they saw their market share rapidly deteriorate. In response, the entire competitive landscape was trying to one up each other. So, what was a meticulous loosening of guidelines, turned into a free for all. Banks were in a constant war with each other to offer new and more aggressive programs.

What was lost was any semblance of reason. Whereas at the beginning, even sub prime frowned on such things as prior bankruptcies, foreclosures, and mortgage lates, by the end, nearly everything was dismissed. Furthermore, the revolution of so called “stated loans” became the fruit of future disaster. Stated started out only for borrowers with uneven or sophisticated incomes: commissioned borrowers, self employed borrowers, or borrowers with multiple investment properties. By 2005, nearly everyone could get a stated loan. As such, folks on salary like teachers, secretaries, and even janitors could get a loan by stating their income without actually providing any income documentation.

By the end of 2006, the industry’s recklessness had reached its limit. The industry had standardized the so called 620 stated/stated no money down loan. This was a loan for a borrower with a credit score of 620 (which is in the bottom third of all credit scores) and this borrower could state but not verify their income, their liquid assets (meaning how much they had in the bank) and do all of this with no money down.

Meanwhile, several things were happening on the securitization side of the business. In 1999, Congress and then President Bill Clinton passed landmark deregulation legislation of banks and financial services companies. What this bill allowed was for investment banks and commercial banks to perform each other’s functions. This had many different effects. For instance, brokerage firms like Merrill Lynch could offer checking accounts, and banks could offer investments. More pertinent to this discussion, it allowed more financial services firms to both package loans together and turn them into bonds, and to buy the buyers of said bonds. So, as the real estate market got hotter and hotter, more and more financial services firms began taking bigger positions in these bonds. Even more troubling was the availability of leverage to buy these bonds. Financial services firms were using margin, and very leveraged margin, to take massive positions in these bonds.

At the beginning of 2007, with no more new loans to create, the real estate market finally took a breather. With the real estate market taking a breather, all of the excesses that were masked by the hot market began to come to light. The entire industry was now discovering that billions of dollars worth of financial vehicles were being held with underlying borrowers with no ability to pay for their mortgage. These excesses were masked by the hot real estate market in several ways. Often these borrowers were able to refinance out of their loans before they got into trouble. Other times, these borrowers were even able to sell and buy new properties. Now that neither option was possible, the industry discovered that billions of dollars worth of assets were attached to “toxic borrowers”. This of course lead to toxic assets. The beginning of 2007 was the end of sub prime.

In the first part of 2007, it looked as though the toxicity would be limited to sub prime. By August, the industry realized that toxicity was wide spread. The next domino to fall was so called Alt A. This is the sub set of loans between prime and sub prime. At about this time, both Fannie and Freddie both asked for massive bailouts as well. These two giants both got themselves far too involved in aggressive loans. When these loans were money makers, they piled on to take massive positions. Now that they went bad, both held billions of worthless assets.

The next major event was in September of 2007 when FASB rule 157, mark to market, took effect. This forced banks to put a current market value on all assets, including billions worth of MBS’. While this rule may seem reasonable, what it did was force a so called write down of billions worth illiquid MBS. Because the market for Mortgage Backed Securities was no longer liquid, these banks couldn’t sell their assets, and each month their balance sheets got progressively worse as they had to apply ever lessening values on their MBS holdings. With shrinking assets, banks needed to raise capital in other places just to meet minimum capital requirements.

The next major event was the near downfall of Bear Stearns. In one weekend, the Federal Reserve orchestrated a multi-billion dollar buyout and essentially brokered a merger between JP Morgan/Chase and Bear Stearns. Of course, this consolidation of power was met with controversy and skepticism, but we were all told that it was necessary to avoid a financial meltdown. As it turns out, it only masked this meltdown for another six months. The meltdown came when the Fed couldn’t do the same for Lehman Brothers that it did for Bear Stearns in September of 2008. Since, we have seen a quick deterioration of wealth, jobs, and gross domestic product. We have been told that there is a credit freeze while financial institutions clean their balance sheets of these so called “toxic assets”.

Worse than this, the tax payers are on the hook for hundreds of billions of tax payer dollars in order to prop up companies like AIG, Citigroup, and the entire banking sector, which the government deems “too big to fail”. Meanwhile, all property owners are seeing the value of their properties disintegrate as rising foreclosures, as well as tightening credit, have seen the housing market shrink.

We are now at a financial cross roads, and all the answers seem to be less than desirable. It is, however, the belief of this white paper that the solutions lie mostly in the free markets. Currently, the administration believes that government interference is the only way to solve the crisis. That’s why the federal government has implemented a mortgage bailout program to modify loans. It’s also why the federal government has spent $750 billion to fund banks. This is the wrong course.

To understand why this course is so corrosive, look back to the original Journal article. What is needed now is a bottom to this economic cycle. At the bottom is when the financial “vultures” will come out looking for deals. The government believes that modifying troubled loans will stabilize housing. Yet, the problem with housing was the availability of loans to borrowers not qualified to own. In order to truly stabilize housing, these borrowers must be removed from the market entirely, not propped up with loans they don’t deserve. Furthermore, millions of borrowers are sitting on the sidelines waiting for prices to fall further. They are the housing vultures. By stabilizing housing artificially, all that will happen is that millions of qualified borrowers will be kept from buying. Furthermore, many of these troubled borrowers will ultimately be foreclosed on. The buyers of these foreclosed properties will also be vultures. Propping up current borrowers will also keep these vultures from taking advantage.

Then, there is the issue of the banking system. The government believes that the proper course of action is to prop up dozens of poorly run banks because their financial ruin would mean the whole system would meltdown. It’s impossible to prove a hypothetical, but one should ask what exactly are we in the middle of now. Far from a meltdown, what letting the free market work would do is create a restructuring. The troubled institutions would do what all troubled institutions do, go through the banking version of bankruptcy. This way their debts would be restructured. It’s also an exaggeration to say the entire banking system would meltdown. Financial institutions like Northern Trust, ABN Amro, and HSBC largely stayed out of sub prime and would survive any so called meltdown. Local and regional banks were also far too conservative to taken sub prime. Far from melting down, all these institutions would be in a position to take advantage of the downfall of many other institutions. In other words, they would all be the vultures swooping in to take advantage. Troubled institutions would also be forced to sell their parts at deep discounts. The prize jewel at Citigroup, for instance, is Smith Barney. If Citigroup were forced to restructure, they would likely have to sell off most of the company, and whoever bought Smith Barney would buy it at a deep discount. They would also be vultures.

Again, it’s impossible to say how deep or how long the meltdown would last if the free market took effect, but again, we should also ask how things are going now. By propping up the entire industry, the government is also giving a disincentive for any “financial vulture” to step in. Without these vultures we never see a bottom.

There are also plenty of places where much needed reform must take place. First, we must immediately suspend mark to market. All this rule does is pervert companies both during times of boom and downturn. Financial institutions hold much of their assets for the long term and so giving each a real time value is itself a perversion of reality. Without mark to market, financial institutions can simply put away many of their so called “toxic” Mortgage Backed Securities without worrying what they will do to their balance sheets.

Second, we must all use this opportunity once and for all for much needed reform to both Fannie Mae and Freddie Mac. To truly understand both is to truly understand the concept of “too big to fail”. Both were creations of the federal government, and are what is called Government Sponsored Entities. They are private companies that also receive federal perks (like treasury credit lines) that other companies do not. Because both securitize loans, they make all the rules. Banks are looking to fund a loan and sell it immediately. As such, they must play by the rules of the securitizers, Fannie/Freddie. Both currently hold about half of all mortgages. That means they literally run the entire industry.

Reforming them is rather simple. They have two structural problems. First, since there are only two of them, they are essentially a monopoly (or technically a duopoly). Second, since they are extensions of the government, they are essentially nationalized companies. Reform means fixing both. As such, they must be broken up into four to eight companies, and they must become fully privatized with no more government perks.

Also, there must be new limits set on just how much margin banks and other financial institutions are allowed to get when they borrow and invest. Many of the problems were caused because banks were leveraged in obscene ways when making investments into MBS. They were leveraged as heavy as five percent. This means that they only put of up five percent of the money they invested. The stock market crash happened in large part because people were allowed to margin as low as ten percent. It should be no surprise that massive margins caused this current crisis. Banks must be forced to come up with much more than five percent of any margin ed investment going forward.

Next, we must also reform the credit default swaps market. This is the field that has caused so many problems to AIG. Credit default is a way to make bets on whether a bundle of assets will default. As such, they are derivatives (a financial vehicle that derives its value from another vehicle). They are a way for the holder of said asset to hedge against failure. In that way, they are sort of like insurance. Yet, this massive market is neither and it is totally deregulated. The main difference is this. Anyone can make a bet in the credit default swaps market on the future default of any asset. As such, any number of bets can be made on the same asset. As such, trillions of dollars worth of bets can be made on billions of dollars worth of assets. There is absolutely no limit to the bets and each bettor need not be tied directly to the asset. No other insurance or derivative works like this. AIG is in such trouble because they took trillions of dollars worth of bets on billions of dollars worth of assets. This must end.

Our country can no longer be held hostage to any company that is deemed “too big to fail”. Whether we need an update to the Sherman Anti Trust Act, or we simply need regulators more aware of the implications of “too big to fail”, we must never again allow any company to become “too big to fail”. The tax payer can no longer be held hostage to corrupt and incompetent companies like AIG that hold everyone hostage for hundreds of billions of dollars because the implication of their collapse is something we simply cannot afford.

Companies that are too big to fail are the antithesis of free markets and capitalism. They operate in neither. They enjoy advantages that others do not. They take risks that others do not. Finally, their risks are paid by the tax payer, and that can no longer go on. Sherman Anti Trust was created to promote competition and free markets, and that’s what it must do. No longer can we allow companies to become too big to fail. They must be broken up prior to this happening.

Finally, we need to take this crisis as an opportunity for serious reform of the Federal Reserve. This crisis and much of the economic instability over the last decade were largely created by the Fed. We simply cannot have a growing economy when our money supply is moved in a pschzophrenic manner. No less than three times over the last decade, the Federal Reserve raised or lowered rates furiously only to have to reverse course within the next two years. How can you possibly have any economic stability when interest rates are so unstable? The Federal Reserve Chairman controls the money supply of the United States. There is no doubt that this is the most powerful position in the world, and yet this individual is not elected. Furthermore, they are rarely even questioned. They are treated as oracles and wizards. The Federal Reserve must come under greater scrutiny, with greater checks, or we will face further economic instability.