Monday, August 31, 2009

CBS News' 60 Minutes: Financial WMDs

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Here is the text of the CBS News' 60 Minutes segment "Financial WMDs" that was broadcast August 30, 2009

The Bet That Blew Up Wall Street

Steve Kroft On Credit Default Swaps And Their Central Role In The Unfolding Economic Crisis

Note: This story was first published on Oct. 26, 2008. It was updated on Aug. 27, 2009.

Anyone with more than a casual interest in why their 401(k) has tanked over the past year knows that it's because of the global credit crisis. It was triggered by the collapse of the housing market in the United States and magnified worldwide by the sale of complicated investments that Warren Buffett once labeled financial weapons of mass destruction.

They are called credit derivatives or credit default swaps.

As correspondent Steve Kroft first reported last fall, they are essentially side bets on the performance of the U.S. mortgage markets and some of the biggest financial institutions in the world - a form of legalized gambling that allows you to wager on financial outcomes without ever having to actually buy the stocks and bonds and mortgages.

It would have been illegal during most of the 20th century under the gaming laws, but in 2000, Congress gave Wall Street an exemption and it has turned out to be a very bad idea.


While Congress and the rest of the country scratched their heads trying to figure out how we got into this mess, 60 Minutes decided to go to Frank Partnoy, a law professor at the University of San Diego, who has written a couple of books on the subject.

Ask to explain what a derivative is, Partnoy says, "A derivative is a financial instrument whose value is based on something else. It's basically a side bet."

Think of it for a moment as a football game. Every week, the New York Giants take the field with hopes of getting back to the Super Bowl. If they do, they will get more money and glory for the team and its owners. They have a direct investment in the game. But the people in the stands may also have a financial stake in the ouctome, in the form of a bet with a friend or a bookie.

"We could call that a derivative. It's a side bet. We don't own the teams. But we have a bet based on the outcome. And a lot of derivatives are bets based on the outcome of games of a sort. Not football games, but games in the markets," Partnoy explains.

Partnoy says the bet was whether interest rates were going to go up or down. "And the new bet that arose over the last several years is a bet based on whether people will default on their mortgages."

And that was the bet that blew up Wall Street. The TNT was the collapse of the housing market and the failure of complicated mortgage securities that the big investment houses created and sold around the world.

But the rocket fuel was the trillions of dollars in side bets on those mortgage securities, called "credit default swaps." They were essentially private insurance contracts that paid off if the investment went bad, but you didn't have to actually own the investment to collect on the insurance.

When 60 Minutes last spoke with Eric Dinallo, he was insurance superintendent for the state of New York. He says credit default swaps were totally unregulated and the big banks and investment houses that sold them didn't have to set aside any money to cover potential losses and pay off their bets.

"As the market began to seize up and as the market for the underlying obligations began to perform poorly, everybody wanted to get paid, had a right to get paid on those credit default swaps. And there was no 'there' there. There was no money behind the commitments. And people came up short. And so that's to a large extent what happened to Bear Sterns, Lehman Brothers, and the holding company of AIG," he explains.

In other words, three of the nation's largest financial institutions had made more bad bets than they could afford to pay off. Bear Stearns was sold to J.P. Morgan for pennies on the dollar, Lehman Brothers was allowed to go belly up, and AIG, considered too big to let fail, is on life support thanks to a $180 billion investment by U.S. taxpayers.

"It's legalized gambling. It was illegal gambling. And we made it legal gambling…with absolutely no regulatory controls. Zero, as far as I can tell," Dinallo says.

"I mean it sounds a little like a bookie operation," Kroft comments.

"Yes, and it used to be illegal. It was very illegal 100 years ago," Dinallo says.

In the early part of the 20th century, the streets of New York and other large cities were lined with gaming establishments called "bucket shops," where people could place wagers on whether the price of stocks would go up or down without actually buying them. This unfettered speculation contributed to the panic and stock market crash of 1907, and state laws all over the country were enacted to ban them.

"Big headlines, huge type. This is the front page of the New York Times," Dinallo explains, holding up a headline that reads "No bucket shops for new law to hit.”

"So they'd already closed up 'cause the law was coming. Here's a picture of one of them. And they were like parlors. See," Dinallo says. "Betting parlors. It was a felony. Well, it was a felony when a law came into effect because it had brought down the market in 1907. And they said, 'We're not gonna let this happen again.' And then 100 years later in 2000, we rolled them all back."

The vehicle for doing this was an obscure but critical piece of federal legislation called the Commodity Futures Modernization Act of 2000. And the bill was a big favorite of the financial industry it would eventually help destroy.

It not only removed derivatives and credit default swaps from the purview of federal oversight, on page 262 of the legislation, Congress pre-empted the states from enforcing existing gambling and bucket shop laws against Wall Street.

"It makes it sound like they knew it was illegal," Kroft remarks.

"I would agree," Dinallo says. "They did know it was illegal. Or at least prosecutable."

In retrospect, giving Wall Street immunity from state gambling laws and legalizing activity that had been banned for most of the 20th century should have given lawmakers pause, but on the last day and the last vote of the lame duck 106th Congress, Wall Street got what it wanted when the Senate passed the bill unanimously.

"There was an awful lot of, 'Trust us. Leave it alone. We can do it better than government,' without any realistic understanding of the dangers involved," says Harvey Goldschmid, a Columbia University law professor and a former commissioner and general counsel of the Securities and Exchange Commission.

He says the bill was passed at the height of Wall Street and Washington's love affair with deregulation, an infatuation that was endorsed by President Clinton at the White House and encouraged by Federal Reserve Chairman Alan Greenspan.

"That was the wildest and silliest period in many ways. Now, again, that's with hindsight because the argument at the time was these are grownups. They're institutions with a great deal of money. Government will only get in the way. Fears it will be taken overseas. Leave it alone. But it was a wrong-headed argument. And turned out to be, of course, extraordinarily unwise," Goldschmid says.

Asked what role Greenspan played in all of this, Professor Goldschmid says, "Well, he made clear in his public speeches and book that a Libertarian drive was part of the way he looked at the world. He's a very talented man. But that didn't take us where we had to be."

"Alan was the most powerful man in Washington in a real sense. Certainly a rival to the president and had enormous influence on Capitol Hill," Goldschmid says.

"And he was at the height of his power," Kroft adds.

Within eight years, unregulated derivatives and swaps helped produce the largest financial services economy the United States has ever had. Estimates of the market for credit default swaps grew from $100 billion to more than $50 trillion, and you could bet on anything from the solvency of communities to the fate of General Motors.

It also produced a huge transfer of private wealth to Wall Street traders and investment bankers, who collected billions of dollars in bonuses. A lot of the money was made financing what seemed to be a never-ending housing boom, selling mortgage securities they thought were safe and credit default swaps that would never have to be paid off.

"The credit default swaps was the key of what went wrong and what's created these enormous losses," Goldschmid says.

"Is it your impression that people at the big Wall Street investment houses knew what was going on and knew the kind of risks that they were exposed to?" Kroft asks.

"No. My impression is to the contrary, that even at senior levels they only vaguely understood the risks. They only vaguely followed what was going on," Goldschmid says. "And when it tumbled, there was some genuine surprise not only at the board level where there wasn't enough oversight but at senior management level."

They didn't know what was going on in part because credit default swaps were totally unregulated. No one knew how many there were or who owned them. There was no central exchange or clearing house to keep track of all the bets and to hold the money to make sure they got paid off. Eventually, savvy investors figured out that the cheapest, most effective way to bet against the entire housing market was to buy credit defaults swaps, in effect taking out inexpensive insurance policies that would pay off big when other people's mortgage investments failed.

"I know people personally who have taken away more than $1 billion from having been on the right side of these transactions," says Jim Grant, publisher of Grant's Interest Rate Observer and one of the country’s foremost experts on credit markets.

"If you can and you could lay down cents on the dollar to place a bet on the solvency of Wall Street, for example, as some did, when Wall Street became evidently insolvent, that cents on the dollar bet went up 30, 40, and 50 fold. Not everyone who did that wants to get his name in the paper. But there are some spectacularly rich people who came out of this," Grant says.

"Who got richer," Kroft remarks.

"Who got richer, who became, you know, fantastically richer," Grant says.

A lot of them were hedge fund managers. John Paulson's Credit Opportunities Fund returned almost 600 percent last year, with Paulson pocketing a reported $3.7 billion.

Bill Ackman, of Pershing Square Capital Management, said he plans to make hundreds of millions. Both declined 60 Minutes' request for an interview.

Congress seemed shocked and outraged by the consequences of its decision eight years ago to effectively deregulate swaps and derivatives. Various members of the House and Senate have hauled in the usual suspects to accept or share the blame.

"Were you wrong?" Rep. Henry Waxman asked former Federal Reserve Chairman Greenspan.

"Credit default swaps, I think, have some serious problems with them," Greenspan replied.

It appears to be the first step in a long process of restoring at least some of the regulations and safeguards that might have prevented, or at least mitigated this disaster after the damage has already been done.

Where do we go from here?

"We need the most dramatic rethinking of the regulatory scheme for financial markets since the New Deal. If anything has demonstrated that imperative, it's the economy right now and the tragic circumstances we're in," Goldschmid says.

Asked how much danger he thinks is still out there, Goldschmid says, "We don't know. Part of the problem of the lack of transparency in these markets has been we don't really know."

To read this article on CBS' Web site, click this link:;segmentUtilities

Wednesday, August 26, 2009

GAO: Auto Enrollment, Mandatory Participation in Retirement Plans Can Boost Retirement Income

The U.S. Government Accountability Office spent a year reviewing alternative retirement plan designs abroad and proposals for new plan designs in the United States to determine which features in these plans could potentially address retirement risks currently faced by American workers. GAO modeled the impact on retirement income potential from defined contribution plans in three scenarios: mandated universal access, automatic enrollment, and mandated employee participation.

GAO found that universal access and mandated employee participation together would increase the share of workers with some defined contribution plan savings at retirement from a current 67 percent level to 97 percent. It would raise the equivalent annuity benefit from a baseline of $15,217 a year to $21,312 a year. In a scenario where there is mandated access and automatic enrollment, but no required employee participation, the results are almost as impressive: the share of workers with savings at retirement rises to 91 percent with an $18,556 annual annuity equivalent.

By Robert Stowe England

August 26, 2009

The U.S. Government Accountability Office has completed an ambitious year-long research project that sought to identify the retirement security risks that American workers increasingly face and looked to find retirement plan designs and features that could help address those risks.

The GAO released the results of its efforts in a 72-page report August 24. The report was completed in late July, but its release was withheld for 30 days by Representative George Miller (California Democrat), Chairman of the House Committee on Education and Labor, who requested the study.

The report is titled Private Pensions: Alternative Approaches Could Address Retirement Risks Faced by Workers but Pose Trade-offs and can be found at this link:

The GAO report finds a number of worrisome trends. For one thing, the share of Americans working in the private sector earning a defined benefit pension – one that pays an annuity income for life at retirement based on their earnings – has declined as employers have terminated or frozen those plans.

Workers increasingly rely on defined contribution plans, which usually pay a lump sum at retirement and rely mostly on employees to save for their own retirement and to make investment choices from among options in a plan.

Another worry is that many workers who are saving through 401(k)’s and other vehicles are not accumulating sufficient funds to be cover their needs and living expenses in retirement.

To bolster its case, GAO cites a 2007 study by Alicia Munnell and others that the median combined balances in 401(k) plans and Individual Retirement Accounts (IRA) totaled $78,000 for people aged 55 to 64. (See Footnote 1.) The 2008-2009 market crashed decimated many of those balances.

Further, older workers in retirement savings plans have failed to move assets away from riskier equities to bonds as they age. A study by Jack VanDerhei, for example, found that nearly one in four people between the ages of 56 and 64 had more than 90 percent of their account balance invested in stocks at the end of 2007. (See Footnote 2.)

GAO identified a range of problems with current retirement savings patterns and arrangements.
• Too few workers are covered (only 50 percent of the private sector workforce).
• Contributions are inadequate.
• Workers face investment risk.
• Benefits are not always portable and when workers change jobs, they often take pre-retirement withdrawals.
• Workers borrow from saved funds or take hardship withdrawals.
• Administrative and investment fees can sometimes eat away much of the investment return.
• Workers tend to draw down benefits early in retirement, leaving too little for later years.
• Retirees continue to face investment risk from the assets in a retirement savings plan.
• Retirees also face inflation risk, as the purchasing power of savings or annuities declines over time.

Barbara Bovbjerg, director of education, workforce and income security at GAO, was in charge of the study and a research team working for her examined the design, features and ultimate benefits provided by private pension schemes abroad. They also reviewed four domestic proposals for new retirement plan designs in the United States.

The GAO researchers sought to identify certain design features of retirement plans that, if adopted, could yield a more adequate benefit in retirement.

GAO reviewed the private sector schemes in the United Kingdom, the Netherlands and Switzerland. They found a number of features in these plans that boosted retirement income and security.

In the United States, the GAO examined the Urban Institute’s Super Simple Saving Plan, the ERISA Industry Committee’s New Benefit Platform for Life Security, The New America Foundation’s Universal 401(k) Plan, and The Economic Policy Institute’s Guaranteed Retirement Accounts Plan.

The domestic proposals were selected, the GAO report states, “because they incorporate strategies to address risks workers face, are developed in enough detail to allow us to fully analyze them, are not duplicative, and have been proposed or considered in the last five years.”

“Neither the pension systems in other countries we reviewed, nor the domestic proposals constitute a panacea for the challenges of the U.S. pension system,” GAO concludes.

“No system or proposal is perfect and each requires careful consideration of the trade-offs between its advantages, costs, and responsibilities,” the GAO report states.

Nevertheless, GAO found that the foreign pension schemes have either yielded impressive results for workers, as in the case of the Netherlands and Switzerland, or promise to significantly improve retirement income, as in the case of the United Kingdom.

“Despite important social, economic, and institutional differences between the United States and these countries, key features from these models, as well as the domestic proposals, are relevant and could potentially offer some solutions for the U.S. pension system,” the report stated.

“Taken together, these key features could be used more comprehensively [to] address risks workers face,” GAO stated. “The challenge for Congress will be to balance the interests and responsibilities of workers, employers, and the government and find the most promising steps to help Americans achieve retirement security.”

Three Modeled Scenarios

For its simulation, the GAO paper has focused on those options that are most likely to increase coverage rates and the amount of the final benefit.

GAO ran its three scenarios through the Pension Simulator (PENSIM), a software model developed to analayze lifetime coverage and adequacy of employer sponsored plans. It was developed by the Policy Simulation Group in Washington, D.C., through the sponsorship of the Employee Benefits Security Administration at the Department of Labor and is one of three simulation models developed by PSG.

The simulations were based on a sample of the 1990 cohort, totaling 126, 518 at birth. GAO, which has the PENSIM software in-house, simulated the timing of lifetime events for this cohort, as well as their future savings through employer-sponsored defined contributions plans.

The three options for which modeled by the Pension Simulator are as follows:

Universal access. All employers that do not sponsor a plan are required to provide a defined contribution plan with no employer contribution. Existing employer-sponsored plans are not affected.

Universal access with automatic enrollment. In addition to universal access, as described above, all defined contributions plans have automatic enrollment in which individuals must affirmatively opt out of participating in the plan.

Universal access with mandatory participation. In addition to universal access, all workers with access to a defined contribution plan are required to participate.

The contribution levels -- an important factor in the outcome of the three scenarios -- is not not described in the report. A description of how PENSIM calculates contribution rates in defined contribution plans has been provided to Mind Over Marekt by Martin Holmer at the Policy Simulation Group and is provided below in Footnote 3.

Basically, the simulations are based on the recent historical patterns of contribution rates in defined contributions plans and includes both employee contributions and employer matches. PENSIM randomly generates contribution amounts and matches for the sample from the 1990 birth cohort.

Employees are assumed to have been invested in life cycle funds, which reduce the level of equity exposure over time as workers near retirement.

The simulations assume a real rate of return of 2.9 percent on investments in participants' accounts.

Scenario One

GAO found that requiring universal access where participation is voluntary increases the share of workers with defined contribution savings at retirement from 67 percent to 79 percent.

The increase in coverage is greatest for low-income workers, where the share with some defined contribution savings rises from 48 percent to 63 percent.

Requiring universal also boosts retirement income, GAO found. Using a measure of the annuity equivalent of the accumulated balance in the plan, GAO found that average household benefit would rise 12 percent – from a baseline of $15, 217 to $17,058 a year in constant 2008 dollars.

Scenario Two

Adding automatic enrollment to universal access yielded even better results. Under this scenario 91 percent of workers have defined contribution savings at retirement. For low-income workers in the bottom quartile of earnings, the coverage rate would rise from 653 percent under universal access alone to 84 percent.

Overall, the projected average pension income would increase to $18,556 from the baseline $15,217.

Scenario Three

Requiring all private sector workers to participate in a defined contribution plan yields the “largest overall gains compared to the baseline,” GAO concludes.

The share of workers with defined contribution savings at retirement rises to 97 percent. For low-income workers, it rises to 96 percent, which is 14 percentage points higher than simply providing universal access.

The average income would rise to $21,312, compared to the $15,217 baseline. For the low income quartile, income would rise to $5,157 from $2,761 in the baseline scenario.

Foreign Schemes

The model scenarios yield coverage rates and benefits that are more in line with some of the benefits to be found in the foreign pension schemes reviewed in the GAO study.

In the Netherlands, the predominant plan is a career-average defined benefit plan and coverage and contributions are mandatory for most employers and workers. Employers contribute 7 to 19 percent of pay, while workers contribute 3 to 8 percent of pay. Not surprisingly 90 percent of workers are covered. The goal for this plan is to replace 70 percent of pre-retirement pay, when combined with a basic Social Security plan.

In Switzerland, the predominant retirement benefit is a cash balance plan (a hybrid of the defined benefit plan), and coverage is mandatory with 90 percent of workers covered. Both employers and employees are each required to contribute 3.5 to 9 percent of pay. The contribution levels rise with age. The goal for this plan is to replace 60 percent of pre-retirement pay, when combined with Social Security.

In the United Kingdom, there is a new Personal Accounts plan, which consists of defined contribution plans. When fully phased in, employers will contribute 3 percent of pay, employees will contribute 4 percent of pay, and the government will contribute 1 percent of pay. The goal for this approach is to replace 45 percent of pre-retirement income, when combined with Social Security.

In all three countries the majority of the benefit, usually 75 percent, must be taken as an annuity to ensure that retirees are less likely to outlive their retirement funds.

Copyright © 2009 Robert Stowe England

Footnote 1. Alicia Munnell, Francesca Golub-Sass, and Dan Muldoon, “An Update on 401(k) Plans: Insights from the 2007 Survey of Consumer Finances,” Center for Retirement Research at Boston College, March 2009.

Footnote 2. Jack VanDerhei, “The Impact of the Recent Financial Crisis on 401(k) Account Balances,” Employee Benefit Research Institute, Issue Brief, no. 326 (Washington, D.C., February 2009)

Footnote 3. It would seem, based on the Note to Table 12 on page 53 and to Table 13 on page 63) that GAO used the baseline PENSIM assumptions about defined contribution plan contribution rates, according to Martin Holmer at the Pension Simulation Group in Washington, D.C. The baseline contribution assumptions in PENSIM are based on employee contribution behavior, observed in the EBRI-ICI database of 401(k) participants at the end of the 1990s, and on employer matching behavior, observed in the late 1990s BLS Employee Benefit Survey, which is now called the National Compensation Survey. The details about how this information is incorporated into PENSIM is thoroughly documented in the PENSIM Overview document, which is available on the Documentation page of the Policy Simulation Group web site at this link: The PENSIM Overview discusses employee contribution rates in three sections (going from general to specific), which are on pages 14-15, pages 145-146, and pages 224-225. In the EBRI-ICI data, the employee contribution rate varies widely by age and earnings level and for unknown reasons. See, for example, the chart on page 5 of the EBRI Issue Brief 238. In addition to this variation among those who make a positive contribution, a small group of plan participants make zero contributions in a year. This behavior is simulated in PENSIM along with the wide variation among those with positive contributions. PENSIM simulates in detail all the federal rules that limit high contributions. And remember that while the dollar limits are inflation indexed, after many decades the limits will be lower when measured relative to earnings (which are projected to grow faster than prices). This is relevant because GAO is simulating a sample of individuals born in 1990, whose peak earnings years will be during the 2040s and 2050s. Martin Holmer reports that the Policy Simulation roup has conducted a number of validation tests of defined contribution plan balances simulated by PENSIM. In comparisons with both data from EBRI-ICI and from the 2004 Survey of Consumer Finances, we find PENSIM simulated defined contributionC balances are quite similar to those observed in real-world data. For more on those validation tests, see PENSIM Overview, Chapter 10.

Thursday, August 20, 2009

Deutsche Bank: Half of U.S. Homeowners with Mortgages Will Be 'Underwater' by 2011

Deutsche Bank estimates that 14 million, or 26 percent of homeowners with mortgages, owed more than their house is worth in the first quarter of 2009. An estimated further 14 percent decline in home prices will drive up the number of homeowners with negative equity to 25 million or 48 percent of mortgagors by the first quarter of 2011, the bank forecasts.

By Robert Stowe England
August 20, 2009

Hopes that the housing market is now beginning to stabilize have been dampened by the release of a Deutsche Bank forecast on the level of negative equity among U.S. homeowners with mortgages.

The study, "Drowning in Debt -- A Look at 'Underwater' Homeowners," was authored by Karen Weaver and Ying Shen at Deutsche Bank's U.S. research unit and can be found at this link:

Based on analysis of data on 6.7 million non-agency loans compiled by First American CoreLogic's LoanPerformance and 5.5 million loans in Freddie Mac's loan level agency data, the Deutsche Bank researchers estimate that 14 million households with mortgages were "underwater" in the first quarter of 2009.

Of the 110 million households in the United States, 75.5 million are homeowners and 68 percent of this group, or 51.6 million households, have mortgages on their homes, the report states.

Thus, the 14 million "underwater" households represent 26 percent of all homeowners with mortgages.

By 2011, however, Deutsche Bank estimates this will rise to 25 million or 48 percent of all mortgagors, a staggering increase in "underwater" households that is likely to be a considerable drag on economic prospects.

Deutsche Bank's estimate is based on its June outlook for home prices in the top 100 Metropolitan Statistical Areas, which can be found at this link:

Deutsche Bank forecasts that home prices would fall an additional 14 percent on a national level from the prices in the first quarter of 2009, reaching a bottom or trough at the end of the first quarter of 2011 -- about six quarters from now.

This forecast means that , from their peak in 2005 to the trought in early 2011, U.S. home prices will have fallen 41.7 percent, according to Deutsche Bank.

Deutsche Bank's first quarter 2009 estimate of the number of underwater households is similar to the 15 million estimated by for the first quarter and to the 11 million estimated by First American CoreLogic in the fourth quarter of 2008.

However, Deutsche Bank's forecast is decidedly more pessimistic than the one made in June by, which projects 18 million "underwater households" at the peak. The study by Mark Zandi can be found at this link:

The's estimates are based on credit file data from Equifax. Also, sees only a further 9.8 percent decline in home prices from the first quarter of 2009.

Prime Loan Deterioration Ahead

Deutsche Bank looks at the problems with negative equity by loan product type and sees deteriorating conditions even for prime credit quality home borrowers.

"While subprime and Option ARMs are currently the worst cohorts with underwater borrowers, we project that the next phase of housing decline will have a far greater impact on prime borrowers," the Deutsche Bank report states.

Option ARMs (adjustable rate mortgages) allow customers to choose among several payment levels each month with a minimum payment that, depending on the prevailing interest rate, can add additional mortgage debt to the principal, reducing the equity in the home.

Even for the most conservative category of loans -- so called conforming, conventional loans -- the share of homeowners with these loans who are underwater will rise from 16 percent in the first quarter of 2009 to 41 percent in the first quarter of 2011.

These conforming loans meet the underwriting guidelines of Fannie Mae and Freddie Mac and fall below a conforming loan limit amount, are within a debt-to-income ratio limit and are fully documented.

About 29 percent of homeowners with prime jumbo loans, those held by prime borrowers but which are above the loan limits for Fannie Mae and Freddie Mac, were already underwater early this year. By early 2011, 46 percent will be underwater.

The silver lining, if one can call it that, is that the share of underwater borrowers in nontraditional loans is already sky high. For example, 77 percent of homeowners with Option ARMs were already underwater in the first quarter of 2009. By the end of the first quarter of 2011, 89 percent will be underwater.

Option ARMs would, thus, take the prize as the most toxic of mortgage products.

Subprime loans are not far behind. While 50 percent were underwater in the first quarter of 2009, 69 percent will be underwater by early 2011.

Homeowners with Alternative-A or Alt-A loans, which have less documentation the conventional mortgages, are almost as deeply underwater as those holding subprime loans.

Deutsche Bank estimates that 50 percent of Alt-A homeowners were underwater early this year and that by early 2011, 66 percent will be underwater.

What may be almost as troubling is that the homeowners included among those with positive equity include "borderline" homeowners whose loan to home value ranges from 90 percent to 105 percent. That represented 23 percent of homeowners in the first quarter -- pushing the combined negative equity and borderline equity to 49 percent.

In 2011 the mortgages with combined negative equity and borderline positive equity will be 69 percent.

The Worst Markets

Deutsche Bank also looks at 371 MSA's and makes an estimate of how many mortgagors are currently underwater. MSA's are Metropolitan Statistical Areas, which the U.S. Census Bureau defines as one more more adjacent counties with an urban core of at least 50,000 people.

Since Deutsche Bank only forecasts home prices for the top 100 MSA's in June, for its estimates of underwater homeowners, it applies the national average of home price declines in its forecast to the remaining 271 MSA's.

This method of forecasting may overstate the share of underwater mortgagors for 2011 because the worst price declines have occurred in the major metropolitan areas. One couuld make a credible case that the smaller MSA's would have average price declines below the average found in the top 100 MSAs.

In any case, Deutsche Bank finds the highest level of underwater homeowners in the states where price appreciation was the greatest during the bubble period.

Topping the list for underwater mortgagors in earlhy 2009 are three central valley California MSAs: Merced (85 percent), El Centro (85), and Modesto (84). Las Vegas, Nevada (81), and Stockton (81) Bakersfield (79) in California, and Port St. Lucie in Florida (79) are next in line.

As for the peak in 2011, Ft. Lauderdale-Pompano Beach-Deerfield Beach, Florida will top the list at 93 percent of loans underwater, according to Deutsche Bank. El Centro (92 percent) and Merced (91) in California, and Miami-Miami Beach-Kendall, Florida (90) and West Palm Beach-Boca Raton-Boyton Beach, Florida (90) are next in line.

Copyright © 2009 Robert Stowe England

Tuesday, August 4, 2009

A Conversation with FDIC Chairman Sheila Bair

The chairman of the Federal Deposit Insurance Corporation shares her views on navigating the banking system through the current financial market crisis.

By Robert Stowe England

Mortgage Banking
August 2009

Sheila C. Bair was sworn in as chairman of the Federal Deposit Insurance Corporation (FDIC) on June 26, 2006, for a five-year term. As FDIC chairman, she has presided over an exceedingly tumultuous period in the nation’s financial sector. She has helped transform the agency with programs that provide temporary liquidity guarantees, increases in deposit insurance limits and systematic mortgage loan-modification relief for troubled borrowers.

Before joining FDIC, she was Dean’s Professor of Financial Regulatory Policy for the Isenberg School of Management at the University of Massachusetts at Amherst from 2002 to 2006. While there, she served on the FDIC’s Advisory Committee on Banking Policy.

Prior to taking the helm at FDIC, Chairman Bair had considerable experience in government. She was assistant secretary for financial institutions at the Department of the Treasury from 2001 to 2002; senior vice president for government relations at the New York Stock Exchange from 1995 to 2000; a commissioner and acting chairman of the Commodity Futures Trading Commission from 1991 to 1995; and research director, deputy counsel and counsel to Senate Majority Leader Robert Dole from 1981 to 1988.

During her FDIC tenure, Bair has received a number of prestigious honors. In 2008, for example, Forbes magazine named her the second-most powerful woman in the world after Germany’s Chancellor Angela Merkel. In 2009, she has been awarded the John F. Kennedy Profile in Courage Award ® – an annual award by the John F. Kennedy Library Foundation made by a bipartisan awards committee, honoring people in public service who exemplify the ideals in John F. Kennedy’s book Profiles in Courage – and was named one of TIME (end) magazine’s “TIME 100” most influential people.

At FDIC she has also championed the creation of the Advisory Committee on Economic Inclusion, research on small-dollar loan programs and the formation of broad-based alliances in regional markets to bring underserved populations into the financial mainstream. She also received in 2009 the Hubert H. Humphrey Civil Rights Award, an award presented annually by the Leadership Conference on Civil Rights to celebrate the legacy for former VP Humphrey, a civil rights champion in 2009.

Bair received a bachelor’s degree from Kansas University, Lawrence, Kansas, and a juris doctorate from Kansas University School of Law.

Mortgage Banking interviewed Chairman Bair in mid-July to get her thoughts about the progress that has been made in addressing the fallout from the financial crisis.

The entire Q&A with Chairman Bair appears below, but readers can also read a view-only version of the article as it appears in Mortgage Banking at this link:

Q: Where do you think we are in addressing the financial crisis that emerged in 2007 and which grew dramatically worse after the failure of Lehman Brothers in September 2008? Broadly speaking, what has been accomplished so far? What remains to be done?

A: Since the financial crisis began, government and industry together have taken extraordinary steps to maintain the stability of our financial system. All of the government measures put in place over the past several months have been taken to restore confidence in the nation’s financial institutions, including a substantial expansion of guarantees for bank liabilities by the FDIC, injections of capital by the Treasury in many institutions both large and small, and Federal Reserve programs to provide liquidity to financial institutions and support the normalization of key credit markets.

These efforts averted serious threats to global financial stability last fall and have contributed to gradual improvement in key credit markets, though many markets remain stressed.

As a result, we’ve moved beyond the liquidity crisis of last year, and we’re cautiously optimistic that the industry as a whole is getting on a better footing. But there is still more pain ahead because of the problems in housing, which is still looking for a bottom. At the FDIC, we’ve aimed our policy initiatives at preventing a destructive overcorrection in housing that could further damage our economy and our financial institutions. While we’ve had to close nonviable institutions (and closings are expected to keep rising into next year), the FDIC and other regulators are working to improve the ability of other institutions to keep making loans to creditworthy borrowers.

Q: One of the largest bank failures you have handled is the one for Indymac, Pasadena, California. Could you give us an update on what is happening with Indymac? To what extent have the loan modifications at Indymac been successful in preventing foreclosures? What has been the re-default rate on the early modifications done with the loans from the Indymac portfolio? Has the re-default rate improved on Indymac’s more recent modifications and what has been key to that performance improvement if one has occurred?

A: On March 19, 2009, all deposits of Indymac Federal Bank FSB were transferred to OneWest Bank FSB [Pasadena, California]. OneWest Bank continues to apply the FDIC loan-modification protocol to all delegated first-lien mortgage loans it services. Through June 24, 19,924 borrowers have accepted the modification offer, returned the appropriate documentation and were approved for modification.

The approval process includes income verification via recent pay stubs and/or tax returns. This is an important step in the modification process, as it minimizes re-default and ensures the affordability standard is uniformly implemented. An additional 1,873 have recently responded to a loan-modification offer and are currently in process. OneWest Bank is currently applying for the Obama Administration’s Home Affordable Refinance Program (HAMP), which is part of the Making Home Affordable effort.

As of April 30, the re-default rate (defined as loans classified as 60 days or more delinquent) for all modified loans was 13.5 percent. Modification activity through April reduced the expected loss given foreclosure by an estimated $525 million.

Modified loan performance has improved significantly since the first modifications were mailed in August. This is attributed to several factors. First, the modification process has become a fully operational business function, with trained loss mitigators and call-center staff, systems for recording and processing modifications, income-documentation processes and an early re-default calling campaign. In addition, the initial population eligible for modification at Indymac was largely populated by seriously delinquent borrowers; this group of borrowers is less likely to perform than borrowers recently entering the delinquency pipeline. Finally, the FDIC loan modification program reduced the target front-end debt-to-income (DTI) ratio from 38 percent to 31 percent.

Given improvements in operations and the characteristics of borrowers receiving loan-modification offers, performance has improved significantly since program inception. Initial modifications had a 60-day delinquency rate of 22.7 percent after three months’ seasoning. This figure declined rapidly in ensuing months to around 14.5 percent. Additionally, the decrease in DTI standard notably improved performance. Loans modified to the 31 percent DTI standard are showing a 60-day delinquent rate of 3.9 percent compared to a 10 percent [rate] for loans modified to the 38 percent DTI standard with similar seasoning.

Q: The Obama administration's Home Affordable Modification Program has been very slow to get off the ground. Why is that? The largest servicers are signed on, so what has been the hold-up in getting more modifications done? Did you think the program you instituted in the wake of the Indymac failure was a better way to go with modifications, and what aspects of that approach were adopted in the Obama administration’s mod plan?

A: Questions on implementing HAMP should be directed to Treasury or the program administrator, Fannie Mae. However, it is worthwhile to note insights gained from the Indymac experience. Implementing a streamlined bulk-modification program is a resource-intensive effort. It requires servicers to change their traditional loss-mitigation strategy from one based on customized loss-mitigation solutions to a standardized modification model.

For example, prior to the first modification offer mailing, the servicer must undertake these lengthy initiatives: train loss mitigator and call-center staff; improve servicing systems to effectively record and report on modification activity: review applicable servicing contracts; determine compliance issues; develop marketing materials; and develop an income-verification process.

Meanwhile, servicers are stretched to capacity managing portfolios with growing numbers of delinquencies and foreclosures. The first-lien HAMP was announced March 4, with the final supplemental directive issued April 6. Modification activity will increase in late summer to early fall as servicers develop the required infrastructure to respond to the volume of distressed borrowers requesting loan modifications.

Q: Have investors been the hang-up in preventing banks from doing more loan modifications? Will the newly enacted safe harbor for servicers to modify loans help overcome that problem and produce a wave of new modification activity?

A: Loan modifications affect the cash waterfall in securitized transactions, causing different concerns for different investor classes. Ultimately the servicer must adhere to the Pooling and Servicing Agreement or other legal document governing the transaction. A servicer’s best defense against criticism or possible litigation is a uniform modification program with clear eligibility guidelines and a rigorous net present value (NPV) test, which compares the estimated value of modification to the estimated loss given foreclosure, to ensure that the modification results in a lower cost.

The HAMP provides this structure and is reinforced by the safe harbor for servicers. While this will encourage modification activity, the largest gains in modification activity will occur once servicers implement HAMP and put in place internal procedures for evaluating and processing loan modifications.

Q: How would you describe the role played by the Temporary Liquidity Guarantee Program [TLGP] in unfreezing many debt markets? Do you think those guarantees need to be extended?

A: The FDIC’s Temporary Liquidity Guarantee Program has helped stabilize the financial markets by providing additional liquidity to institutions. By guaranteeing bank liabilities, TLGP has provided a backstop to business checking accounts and interbank lending, thus helping financial institutions fund themselves so that they can make loans to creditworthy borrowers.

We are now seeing positive signs of recovery in the debt markets, and are working to wind down the program at the end of October. At the end of May, there was approximately $346 billion in outstanding debt guaranteed under the TLGP. Importantly, TLGP debt outstanding has a longer term at issuance compared to debt outstanding at the end of 2008. As of May 31, only 23 percent of the debt outstanding was issued to mature in 180 days or less, compared to 49 percent at year-end 2008. More than two-thirds of debt outstanding--69 percent--was in medium-term notes, compared to 44 percent at year-end.

In another positive sign, several banks have issued debt not guaranteed by the FDIC, including debt with long-term maturities ranging from five to 10 years.

The FDIC has already extended the duration of the TLGP debt guarantee program. The transaction guarantee component continues until Dec. 31, 2009, but we are considering two options for this program. One option is to extend coverage through June 30, 2010, and raise premiums from 10 cents to 25 cents for every $100 of covered deposits. If we choose this extension, banks that currently participate in the program would have the opportunity to opt out before the extended phase begins. The other option is to maintain the current expiration date.

Q: What will it take to revive the jumbo mortgage-backed securities [MBS] market, and should banks be involved in that segment of the market? What regulatory controls need to be put in place for the private jumbo MBS market to function efficiently and safely once again? When do you expect that part of the market to reemerge?

A: For our mortgage finance markets to function efficiently and safely going forward, we need to tighten consumer-protection rules and restore back-to-basics lending practices. The mortgage industry must set strong standards for underwriting, disclosure and data transparency before investors will come back to private mortgage securities.

The complex structures that obscured risk must be abandoned. Efficient markets work on the ability of all market participants to accurately understand and price risk. We need products and processes that are simple and transparent, so that investors, lenders and consumers alike are informed of the risks. And certainly part of the solution will involve a greater level of government oversight and enforcement.

Q: To what extent have expanded deposit guarantees played a role in containing the banking crisis and in restoring confidence in the banking system? Do you think those guarantees need to be extended? Have there been any losses? How much has the FDIC earned from its loan guarantees?

A: The FDIC has expanded deposit guarantees through two actions. The first was taken under the Emergency Economic Stabilization Act of 2008 and applies to all insured depository institutions. It temporarily increased deposit insurance coverage from $100,000 to $250,000. The second action was taken under our Temporary Liquidity Guarantee Program and applies only to those insured depository institutions that choose to opt in to the program. Under TLGP, the FDIC created the Transaction Account Guarantee (TAG) to provide a full guarantee of non-interest-bearing deposit transaction accounts until Dec. 31, 2009.

Both guarantees have contributed importantly to the gradual easing of liquidity strains on our financial institutions and are an integral part of the coordinated effort by the FDIC, the Treasury and the Federal Reserve to address unprecedented disruptions in the credit markets and the resultant inability of financial institutions to fund themselves and make loans to creditworthy borrowers. They are an important element in efforts to move our economy forward.

Though funding conditions have eased somewhat, the temporary increase in deposit insurance coverage to $250,000 has been extended through 2013. The FDIC is considering the potential extension of TAG for an additional six months in order to facilitate an orderly end to the program.

Over 7,100 insured depository institutions are participating in the TAG component of the TLGP, accounting for an estimated $700 billion in expanded coverage. At the time it was developed, there was concern that many account holders might withdraw their uninsured balances from insured depository institutions. TAG was designed to improve public confidence and encourage depositors to leave their large account balances in those institutions. The program has been an important source of stability for banks with large transaction account balances.

Q: The board of directors of the FDIC this spring levied an emergency charge and raised annual premiums. At the time, you stated that the FDIC expects bank failures to cost about $65 billion over the next five years, much of it this year and next. This is in addition to $18 billion in losses last year. Could you update our readers on how many bank failures there have been, and do you still expect losses at around $65 billion? How soon will these new premiums replenish the FDIC reserve fund so that it is again equal to1.15 percent of insured deposits?

A: As of July 14, there have been 53 bank failures so far this year, compared to 25 in all of 2008. We now expect losses to total $70 billion over the next five years but, again, much of these losses are expected in 2009 and 2010. The FDIC imposed a special assessment of 5 basis points on assets minus Tier 1 capital as of June 30, 2009, and will collect this special assessment in September 2009 along with the regular quarterly assessments that were increased this year. We expect the fund to reach 1.15 percent by 2015.

Q: There has been an enormous amount of interest in the legacy loan program to be administered by the FDIC. To the extent that losses on loans have increased since that program was announced, do you still believe it has the potential to remove a significant level of troubled assets from bank balance sheets? How would you describe the level of interest in this program by potential purchasers of those loans? Do you think banks will be willing to participate, given the fact they might not get the prices they would hope to get? When do you now expect to get this program off the ground with the first auction?

A: On June 3, the FDIC formally announced that development of the Legacy Loans Program (LLP) will continue, but that a previously planned pilot sale of assets by open banks would be postponed. Banks have been able to raise capital without having to sell bad assets through the LLP, which reflects renewed investor confidence in our banking system. As a consequence, banks and their supervisors will take additional time to assess the magnitude and timing of troubled assets sales as part of our larger efforts to strengthen the banking sector.

As a next step, the FDIC will test the funding mechanism contemplated by the LLP in a sale of receivership assets this summer. This funding mechanism draws upon concepts successfully employed by the Resolution Trust Corporation in the 1990s, which routinely assisted in the financing of asset sales through responsible use of leverage. [By the time this interview is published, the FDIC is expected to have already solicited] bids for this sale of receivership assets. The FDIC will continue its work on the LLP and will be prepared to offer it in the future as an important tool to cleanse bank balance sheets and bolster their ability to support the credit needs of the economy.

Q: What changes do you think are needed in the regulation of financial institutions? Do you believe that the securitization market for loans should come under great regulatory oversight, given the role mortgage-backed securities and their derivatives have played in creating the credit and banking crises?

A: There are many different types of financial product and service providers. While the banking industry certainly should bear its share of the blame for the current financial crisis, many abusive products and practices originated in the unregulated sectors of the financial marketplace and these firms should be held accountable for their actions as well.

The confidence of consumers and investors in financial markets has been shaken to the core. And it can only be restored with the commitment of financial professionals who insist on the highest possible standards for consumer protection and for safe and sound business practices, in all parts of the industry.

As well, the private mortgage securitization business must be restarted and placed on a sounder footing. At the height of the housing boom, in 2005 and 2006, more than $1 trillion in private residential mortgage-backed securities [RMBS] were issued a year. By the second half of last year, however, that market had virtually shut down. Restarting this vital method of mortgage finance is going to require a great deal of discipline, care and restraint from everybody.

The mortgage industry must set strong standards for underwriting, disclosure and data transparency before investors will come back to private mortgage securities. The complex structures that obscured risk must be abandoned. We need simpler, more standardized deals that everybody can understand, and where performance can be readily analyzed. We need to make sure that incentives are aligned among all parties by making compensation contingent on the long-run performance of the underlying loans.

Q: Do you think leverage requirements should be part of any financial regulatory reform in the United States, regardless of what happens to Basel II capital requirements?

A: Although the intense public debate over Basel II seems like a thing of the distant past, I remain committed to the idea that leverage requirements are important for banks not just in the United States but around the world. By providing capital even when risk-based measures (erroneously, as it turned out) indicate minimal risk, the leverage ratio is a critical part of our overall approach to capital regulation. When we emerge from this crisis, a top priority must be crafting a sound capital framework that helps avoid a repeat of past problems; it should include a leverage ratio.

The Basel Committee is in the process of changing capital rules in a number of areas. There will be improvements. But for most banks, these improvements are unlikely to offset what we see as a capital-lowering bias that is essentially baked into the advanced approach. With the dangers of excessive leverage so clearly demonstrated over the last 18 months, it would be imprudent to determine regulatory capital based solely on the advanced approach.

I strongly believe that global leverage capital requirements are sorely needed. They should apply to all systemically important financial firms, regardless of charter. Unlike the current system, they would set a capital floor for the advanced approach, which would limit excessive leverage in the future.

Q: Do you have any views you would like to share on the future of non-depository independent mortgage bankers and lenders?

A: I think that it is important that we ensure that non-depository independent mortgage bankers and lenders are subject to the same standards and controls as regulated chartered institutions. One of the lessons of the crisis is that we cannot have conflicting standards that put downward competitive pressure on lending standards. The best type of mortgage is one that the borrower can afford, understand and will perform on. That’s common sense that will serve both industry and borrowers.

Q: Finally, would you like to comment on what it has been like to be at the helm of the FDIC in this extraordinary time of financial turmoil?

A: It’s unquestionably been a hectic time at the corporation. Through last fall, there were many late or all-nights, including weekends. What it has demonstrated is how important the FDIC is in times of crisis. This agency was born of a financial crisis and continues to excel in them. The FDIC has extraordinarily hardworking and dedicated staff in every division. Some of the decisions and choices that we have had to make--while sometimes difficult--have proven instrumental to helping to stabilize the financial system. I’m honored and humbled to have had the opportunity to lead the corporation through this period. MB

bio: Robert Stowe England is a freelance writer based in Arlington, Virginia. He can be reached at

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