Saturday, December 31, 2011

Radio Interview: Subprime CDOs Played a Starring Role in the Financial Crisis

The Norris Group's Real Estate Radio Show
Riverside, California
December 31, 2011
Bruce Norris Interviews Robert Stowe England
Topic: Black Box Casino

Listen to the broadcast at this mp3 link:

Summary of the Interview:

This week Bruce is joined once again by Robert England. Robert is a journalist and author who has written extensively on mortgage finance, banking, retirement policy, and the financial and economic impact of aging population. His most current work is Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance. Previous works include Aging China: The Demographic Challenge to China’s Economic Prospects. Robert is also a senior writer for Mortgage Banking Magazine.

In our minds, we used to think that we would go to the bank, get a loan, make a payment to them until we paid it all off, then they hold the loan the whole time. This was called a portfolio loan. It was not until late 2007 when Bruce heard the term mortgage-backed security and CDO.

Bruce wondered if, therefore, at the time this was commonly understood by people who were even in the loan business. Did they understand the path the paper took and how it was disseminated?

Robert believes the people involved with mortgage originations understood it, although other people involved in the housing sector probably did not understand it as much. They did not understand that the loans were being put into portfolios while securities were being issued against the portfolio so that investors were the ultimate funders of the mortgage loans and not banks. The money was funded temporarily by the mortgage originator. They would obtain a warehouse line of credit from a bank if they were an actual mortgage banker as opposed to a broker. They would have money just to the point that the loan closed, and then the loan was sold to an investor. For the mortgage originator, the investor was either Fannie or Freddie or a bank that was acquiring the loan. They did not really know what happened to the loan after that. They did not have to know this; they only knew that they were creating loans, and the demand for them kept increasing even though the quality was decreasing.

Out of the mortgage-backed security world came a product called a CDO. This is a collateralized debt obligation, which began to be used as early as the 1980s. It was used to take existing corporate debt and roll it into a pool of loans to issue securities against a pool of corporate bonds. This never became a huge amount of business and was tried later for bonds from developing nations and other kinds of debt instruments. The market would rise and fall and vanish away, so someone was always trying to come up with another way to use a CDO, which is just another form of securitization. The 1999 credential came up with the idea of having a CDO that put together mortgage-backed securities into a pool and issued securities against those securities, so you were securitizing securities.

There was also the concept of a tranch, which Bruce thought was brilliant and a good vehicle if done correctly. In the private-label mortgage-backed securities world, they all had tranches even before the CDO, and every deal had as much of the deal as possible set up as AAA rated. These were credit-rating tranches. About 94% of most MBS deals were AAA rated by the credit rating agencies, such as Moodys and Fitch. They were paid fees to buy the Wall Street firms, and they also rated the CDOs. The huge volume of private mortgage-backed securities and CDOs did not really take off until after 1999.

The reason for this was when the Basel Committee for Banking Supervision came up with a concept for having the idea risk-waited capital standards apply to these kinds of financial instruments and to give the credit-rating agencies a job of determining their credit rating, only then did it determine the amount of capital banks would hold against the tranches of the deals. The central bankers never really thought this through and were actually creating a monster here because by giving this role to the credit rating agencies, they had made a big mistake. Ironically, when the idea was first proposed, Moodys Investor Service wrote a letter in response to the proposal and suggested that it not be done and that it would corrupt the credit rating standards and created a moral hazard. Yet, this was ignored, and the various countries, including the United States, adopted the standards in 2001 that gave the credit rating agencies this role.

The same year there was a Gramm–Leach–Bliley Act that also did away with the last of the Glass-Steagall Act and barred the SEC from regulating the investment banking holding companies. The investment banking companies, which were already independent, did not have a prudential regulatory regime since Gramm–Leach–Bliley cast this in stone. There was a battle subsequently with the Europeans over this, and Congress first passed a law allowing a voluntary regulatory regime to be established for the bank holding companies and investment banking firms. All of the banking regulation was based on the idea that banks have deposits, taxpayers are exposed to deposits, and banks hold assets for a long time and therefore we are protecting the taxpayers from losses. However, investment banks do not hold deposits and by the nature of their business should not be holding assets for a very long time but rather should create markets. By adopting a regulatory regime in 2004, the bank holding companies and investment companies were given the incentive to buy and hold assets and the use of tremendous leverage, especially mortgage-backed securities. Risk-weighted capital standards are supposed to discourage banks from picking on assets with high risk, but what they really did was create incentives for banks to take on assets with low capital ratings. The investment banking firms did the same things that banks were doing, which were loading up on the assets.

The money to fund the CDOs came from investors, and it had to rated AAA to attract a lot of money. Two things were going on in the early days of the CDO. There were institutional investors who invested in the CDOs that contained mortgage-backed securities and subprime. Banks were also creating CDOs to get the lower-rated tranches of mortgage-backed securities off their books. They could not sell them, but they were trying to get rid of them, so they would put them into CDOs so it would become AAA rated. The institutional investors had lost interest in the lower-rated tranches of the private-labeled mortgage-backed securities subprime, particularly around 2003. The CDO was a way to recycle those assets that institutions would not buy by turning them into AAAs. You would basically take the worst from one pile, and it magically turned into the new pile of the best. By making it very opaque, some investors who did not understand it could be enticed into investing. These were actually black boxes.

Most of the investors aforementioned were foreign investors. After 2003, the U.S institutional investors were not buying, and the investors who were willing to buy had incentive to buy dollar assets and were looking for bond assets. They had trade surpluses or recycled petro dollars. They had lots of dollar denominated funds, and they needed to invest them in dollar assets in order to avoid currency risks. Therefore, the Asian and European banks and other institutional investors were buying these CDOs without much regard for what was in it, and you could not really know what was in it. They did not quite get the level of risk that was there because they were rated AAA.

Bruce wondered what role the Credit Default Swap played in the world of CDOs. Robert said the Credit Default Swap is a form of insurance in which one side sells credit protection against the bonds or mortgage backed securities that the payments would be made, and the other side buys the insurance. The availability of credit default swap made it possible to create synthetic CDOs on a massive scale beginning around 2005. They had existed before, and people were buying credit default swaps to protect their risks for owning certain tranches of the mortgage-backed securities. They then applied this concept to the CDO, but the synthetic CDO was created entirely with credit default swap. The actual assets were a pool of credit default swaps, and the entity issuing the synthetic CDO was insuring their performance. They would turn around and try to get insurance that would cover their losses if the bonds or notes failed. The provider of that was AIG’s financial products division, which sold all the protection for many years.

There were other companies that did it as well, but not nearly the size. The mono-line bond insurance companies that were looked over by state regulators became involved to their own detriment. When they went out of business, whoever was supposed to obtain the insurance coverage just lost.

What happened was the issuers such as Merrill Lynch, Goldman Sachs, and Citigroup were putting together synthetic CDOs and were providing the insurance. In turn, they often could not buy the insurance. Goldman Sachs was able to, but Merrill Lynch and Citigroup increasingly were not able to buy the protection and continued to put together synthetic CDOs without it. They were the designated back holder at that point. They ended up owning all the super senior tranches, which is part of the deal that is made up of the credit default swaps.

Citigroup tried to hide these assets on their balance sheet as well as their trading accounts. When the investment banking regulation was adopted, the Wall Street firms obtained a provision that allowed them to model anything held in their trading account on their book if it had not traded recently. However, Citigroup was also putting these assets into structured investment vehicles, which are more black boxes off its balance sheet. These were funded with asset-backed commercial paper, which was then backed in some cases by subprime mortgages. The Citigroup had over $50 billion worth of toxic assets at the time of the crisis. They were telling the public they had practically no subprime exposure.

Usually the person holding the credit default swap had the other side of the transaction, but this was not even necessary to get a credit default swap. One person was buying protection, and the other was selling. Merril Lynch was putting together a deal where they were providing credit protection to the other party that was in the deal. Then, someone such as Kyle Bass comes in and says he can buy, Bruce wondered if he could invest in a credit default swap and not have the other side.

Robert responded you can in that you would only take one side, in this case the protection side. You can also bet against some of the various parts of the deal, which is what the hedge funds did. The smart people were buying the protection, and the less smart people were not. The general public did not realize how many bad loans were out there, including investors. They assumed that the deals would function and people would pay their mortgages. They did not see the dangers. However, those with the hedge funds did see the dangers and began to sponsor CDOs in order to create tranches they could bet against. They were selling a product they knew was going to fail, and then they bet against its failure. This was at least what was alleged with Goldman Sachs and the deal that got so much attention in Congress.

What the hedge funds did was slightly different, and it is not clear the extent to which the investment banking firms knew about it or whether the people at the top knew about it. Hedge funds would sponsor CDOs, and they would buy the equity tranch. The banks would then have to sell the AAA and BBB to someone else. There were CDO managers, and the catch funds were not supposed to influence the choice of assets that went into the CDO. That was how investors were assured that this was done with integrity. However, certain hedge funds appeared to influence, but it cannot entirely be proved because it was done in ways where it was difficult to trade. Very often with certain hedge funds, such as Magna Tar based in Chicago, the deals they sponsored and the $50 billion worth of CDOs all failed spectacularly.

The CDO managers picked the worst assets out there. The question is whether Merrill Lynch in this case knew what was going on, and this is still going through litigation. Logically, you would think that they had to know something. The people at the top were probably the ones who did understand what was going on at the time. Interestingly, it seems to happen where they may not even understand completely the concepts that are emerging constantly.

You wonder about someone like Stanley O’Neal, who was supercharging at Merrill Lynch the CDO business at the worst possible moment because they thought it was very lucrative. You have to wonder if they were really that foolish and unaware. It is hard to know.

In Robert’s book, it talks about one trader who actually earned more doing one trade than for what Bear Stearns was sold. Bruce wondered if he used a naked short sale to achieve this. Robert said he did and that naked short selling was almost impossible to do with the uptick rule. You could still do naked short selling, but it was difficult to execute. An uptick means that stock has to rise and move up before it goes back down again. The naked short selling is selling shares of stock that you do not own or borrow. This is illegal and is done to manipulate markets to achieve outcomes that the manipulator desires to do.

In March 2008, somebody bought an option for $1.7 million that would not pay off unless the chair price at Bear Stearns collapsed within ten days. Immediately after this happened, rumors were circulated throughout the industry that Bear Stearns did not have enough cash even though it had $18 billion in cash. Brokerage firms started pulling their money out of Bear Stearns. Within days, they only had $2 billion in cash and were on the verge of collapse. Over the Bear Stearns weekend in March 2008, the sale of Bear Stearns was negotiated by the Fed. In the initial deal, which was only $2 a share, the person who made the $1.7 million bet made $270 million off the bet. The company was sold for $236 million, which was worth less than the corporate headquarters of Bear Stearns.

Bruce read a quote that stated, “Bear Stearns was vulnerable to runs because, like most of Wall Street, it had been funding its operation from short-term secured and unsecured cash. When these short-term arrangements did not roll over, new arrangements could not be secured. Cash was drained out of the firm.” We now have sovereign debt. In his book Boomerang, Kyle Bass has done his job of doing credit default swaps on Greece. He would pay $1100 for $1 million coverage. Bruce wondered if Robert saw the same setup that really damaged the world’s economic mortgages done and if round 2 might be sovereign.

Robert believes this derives from the same problem with giving assets too low a risk waiting, especially in Europe where soverance requires no euro capital. Originally this was supposed to apply to AAAs and AAs, and in fact it does still apply to lower rated tranches. You could own a lot of these assets and fund them through overnight lending, and confidence in the system would vanish and people would want their cash back. They would demand more and more assets. Effectively, the price of the asset was declining, but it was being affected by cash being drained out of the system.

For more information about The Norris Group’s California hard money loans or our California Trust Deed investments, visit the website or call our office at 951-780-5856 for more information. For upcoming California real estate investor training and events, visit The Norris Group website and our California investor calendar. You’ll also find our award-winning real estate radio show on KTIE 590am at 6pm on Saturdays or you can listen to over 170 podcasts in our free investor radio archive.

Wednesday, December 28, 2011

The Fannie and Freddie Hate Storm

Holman H. Jenkins, Jr. writes in a column in the Wall Street Journal December 28:

Like amoebas feuding in a drop of water, pundits have been savaging each other all year over whether Fannie Mae and Freddie Mac "caused" the financial crisis. Lately the argument has become apoplectic.

But the question is phrased badly. Three things happened: a housing bubble, a collapse in lending standards, and a global liquidity panic when markets lost trust in the solvency of financial institutions.

Read more at this link.

Tuesday, December 27, 2011

Why the Left is Losing the Argument over the Financial Crisis

By Peter Wallison and Ed Pinto

American Enterprise Institute
December 27, 2011

The day before Christmas, Joe Nocera did it again—wasted a perfectly good column with another attack on us, Peter Wallison and Ed Pinto.

It’s worth reading for what it says about the Left’s current situation. According to Nocera, we “almost single-handedly” have created a “myth that Fannie Mae and Freddie Mac caused the financial crisis.” Those who have fallen for this myth, according to Nocera, include the congressional Republicans and the Wall Street Journal’s editorial page.

It’s somewhat implausible that two guys at a Washington think-tank, arguing that the financial crisis was caused by government housing policy, could create a widely accepted alternative to the conventional liberal narrative that the financial crisis was caused by the greed and lack of regulation of Wall Street. After all, the conventional narrative was created by the government, propagated by the New York Times, and accepted without question by just about every other major newspaper and electronic mass media outlet, foreign and domestic. Apparently, however, in Noceraworld, threats to the accepted narrative can never be fully suppressed.

Read more at this link.

Saturday, December 24, 2011

Radio Interview: Congress Set Fannie, Freddie on the Road to Ruin

The Norris Group's Real Estate Radio Show
Riverside, California
December 24, 2011
Bruce Norris Interviews Robert Stowe England
Topic: Black Box Casino

Listen to the broadcast at this mp3 link:

Summary of the Interview:

257-TNGRadio – Robert England 12-24-11
Friday, December 23rd, 2011


This week Bruce is joined by Robert England. Robert is a journalist and author who has written extensively on mortgage finance, banking, retirement policy, and the financial and economic impact of aging population. His most recent work is Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance. Previous works include Aging China: The Demographic Challenge to China’s Economic Prospects. Robert is also a senior writer for Mortgage Banker Magazine.

Bruce said he really appreciated his Black Box Casino book and was familiar with the overall story. There are a lot of insider terms where when you are in Wall Street and you watch Squawk Box, they use the terms as if the world knows what they mean when they don’t. One thing his book really did that was very helpful was every time he had one of these words to use, he took time to explain what it means. Robert said he did this after a copy editor was reviewing his work that had a general but no financial background, so she kept saying she did not know what something meant. Since she did not understand what words meant, then Robert decided that he needed to define the term. Bruce said it was really helpful because there are some things you hear and you just pretend you know, but then you realize when you have to explain it to somebody that you really don’t know what it means.

The book talks about events as they unfolded in 2007 and 2008, yet Robert had just written the book in 2011. The reason for the long gap of time was it took a while for him to find a publisher who was interested and also to obtain a book contract. This was part of the reason. Another reason was information came out later on that was more helpful than what was available immediately after the crisis. This included a lot of research that was dug up by the financial crisis. Bruce wondered if as time passed people were more apt to say what really went on because there was a safety of distance between the events. Robert said this was probably true for some sources in the book; but for other sources they clammed up because whatever they had been involved with was being embroiled in lawsuits, so they did not really want to talk.

The name Black Box Casino is a concept that describes the change that was occurring in the global financial system. First, there was the increasing prevalence of black boxes within the system, which are financial instruments and institutions that have no transparency; you can’t see what is going on inside and therefore they are black boxes. The casino part of the title comes from learning that much of the activity that went on in a number of the black boxes was in fact speculation, even wild speculation.

Bruce said when we used to think of Fannie and Freddie; we used to think of the safest possible loan pool with a mandate to keep safety as first priority. Bruce wondered how wrong this perception is, to which Robert said this is completely 180 degrees from the reality that was going on at Fannie and Freddie. The way the regulation was set up to govern Fannie and Freddie did not guarantee that they would be operated in a safe and sound manner, and it may in fact have encouraged them to do the opposite.

Bruce wondered if the title of GSE (Government Sponsored Enterprises) came with benefits. Robert said it does because the government is sponsoring what you do, yet you are a private corporation that has shares that are publicly traded and that benefit the executives of the company if they can use the public mission of the corporation to increase revenues and profits for themselves. It is a hybrid form of a business that comes with a lot of problems and can reap a lot of damage if things get out of hand.

Bruce also wondered if the political club had considerable political clout. Robert said they did because both Fannie Mae and Freddie Mac had a considerable amount of clout in the beginning before the regulations were set up to govern them. Once the regulations were put in place, there were a number of provisions in the regulations and the statutes that gave them a lot of power. For one thing, they were allowed to lobby and also got involved with making campaign contributions. Even though they were government-sponsored enterprises, logically they should not have been allowed to lobby the government. What happened was by giving them the authority to lobby, or more specifically not prohibiting it, it allowed them to make contributions, influence Congress, and give politicians a way to provide benefits to constituents without having to go through the budgeting process since everything going on at Fannie and Freddie was not involving the budget. Even their regulator was given minimal powers to regulate them, keep them in line; and this in turn gave them more clout. The regulator did not have a source of income from fees, which is usually what the banking regulators have. Instead, they had to go to Congress every year and get funding for their activities; so they were hamstrung by the ways that the law was set up.

This law was the 1992 Federal Housing Enterprise Financial Safety and Soundness Act, which was a very important law but that unfortunately did not live up to its billing. It was supposed to have been set up for safety and soundness, but once Congress got a hold of the original idea and began devising a bill, it was really put together in a way that would benefit politicians the most as it would give them a way to constantly provide a benefit to a constituency, and that benefit would constantly rise over time. There was no way to restrain the lowering of lending standards, which would be required to increase the level of lending to designated populations.

The law contained federal affordable housing provisions, which was a kind of coup for the politicians. Bruce was shocked that they had a mandate they had to loan to low-to-moderate income people a certain percentage of their loans. When the GSE Act was being put together, at that point both Fannie Mae and Freddie Mac had informal goals in place where approximately 30% of their business would be acquiring loans that went to borrowers who were low or moderate income borrowers. That reflected on natural market share or an entity in their position that would not distort the market. The crafters of the legislation wanted to give HUD the right to raise the affordable housing goals that were put into law and to do them on a periodic basis along with constantly raising them without any consideration to whether or not it would impair the safety and soundness of Fannie and Freddie.

What is interesting about all of this is the legislation really came on just after the SNL crisis, so you would think that everyone would be in the mood to create something that was safe and sound. Robert believes everyone was in the mood, but no one was paying attention to what was being done. First of all, the concept that you would now securitize loans would be a predominant way to finance mortgages was thought to be the way they would reduce the potential fallout from a bad period of lending that occurred with the savings and loans, which held their mortgages on their book. When interest rates rose very high, there was a huge mismatch between their assets and liabilities, which did them in. Securitization was supposed to take that risk off the book, but starting with that people thought they had a magic solution. However, they did not put together a regulatory regime that would be capable of assuring the safety and soundness of Fannie and Freddie, from setting up capital standards to allowing them to have investments in portfolio, to not allowing the safety and soundness regulator to raise their capital standards if they deemed that they were inadequate at any point. In addition to having to go to Congress every year for money, the regulator was also not an independent regulator. They were a part of HUD, and they did not have any control over the Affordable Lending Goal and could do nothing about them. HUD did not have to consider safety and soundness when they were considering the goal. There were actually three goals at the time, and the main goal was raised to over 55% by the time of the crisis, so there was a subsequent goal to low income households, which is more narrowly targeted. This had not existed before and began at about 11% and rose to nearly 27% at the time of the crisis.

Bruce wondered how people qualified for the loans, whether they were really subprime or if they were good credit but low income. Robert said over time the lending standards at Fannie and Freddie declined in order to meet the affordable lending goals. As the goals were put in place gradually, they weakened their lending standards. They first lowered the down payment then gradually lowered the FICO score for borrowers to qualify to be part of the Fannie and Freddie program. They then increased the segment of the business that was funding subprime without identifying that publicly. They drastically increased the amount of business funding Alternative A or low to no documentation loans even more without publicly acknowledging it. The legislation that set up Fannie and Freddie did not require them to file quarterly audited statements to the Securities and Exchange Commission, so they could get away with not telling investors the truth about their portfolio. By the time of 2000, they were doing 100% loan-to-value mortgages and were greatly expanding their subprime lending, but it was never identified as that. This was how we ended up this past week with the SEC filing charges against former Fannie and Freddie executives for lying about the amount of subprime and Alt-A in their portfolios and in their investment holdings. They had a black box, and they were wildly at odds with the actual amount they had.

Bruce wondered if a lot of the fulfillment of the lower income goals happened because they were able to invest in mortgage-backed securities that had the loans in them. Robert said it was both through acquiring them and not calling them subprime, and also through buying private label mortgage-backed securities that had loans that met the qualifications and that would meet the goals. Jim Lockhart, the former head of the Federal Housing Finance Agency, told Robert in a recent interview that they could not have met their goals if they had not bought up a lot of the private label mortgage-backed securities. They bought large amounts of it and were the major purchaser of private MBS. Another reason may have been they were able to leverage it more. Their capital standards were very low, so they could leverage the acquisitions and increase their earnings as well as buy extensions, which was the compensation of the top executives. As a lot of people may know, the former heads of Fannie Mae and Freddie Mac were involved in accounting scandals in 2003 and 2004 where they were found to have manipulated the earnings targets to maximize their compensation. Both Franklin Raines and Leeland Brendsel had to leave the two GSEs at the time. You can jut up the amount of securities you purchase to increase your overall compensation and profitability that was at first profitable but later was not. By creating a compensation system that rewarded the executives by increasing volumes, it really drove the GSEs’ top executives to greatly expand their business in order to make more money.

The leverage for a mortgage-backed security that was stated in the books was 222 to 1, and this was for the guarantee. There were two capital rules. The first was the 222 to 1 guarantee, and the second was Fannie and Freddie had to only hold 0.45% of that capital against the guarantee of paying the principle interest to the investors in their securities. If they held any of the securities that they purchased, they only had to hold 2.5% capital against it. By early 2008, the GSEs were leveraged about 100 to 1 overall when you blend the two on standard accounting rules. The accounting rules were another way that Fannie and Freddie were able to get away with what they did. They did not have to meet what were normally considered bank accounting rules but could use generally accepted accounting principles, which allowed them to use some types of securities and assets to count as their capital when other people did not. This included losses that could be claimed against future taxes. When you are losing money constantly, there is no gain to apply the losses against.

The intended consequences of lowering lending standards was to increase homeownership rates among lower-income and moderate-income households. The homeownership rate was around 64-65% at the time that the GSE Act was passed, and they were hoping to raise it dramatically so that particularly minorities would have homeownership rates similar to those of whites. There was a disparity between both African-Americans and whites and Hispanics and whites in terms of the percentage of the population that owned a home. Although the homeownership rates were about 45%-50% range, they were better than a lot of people might have thought. However, they were not in the mid to high 60s. There was legislation in the 70s that tried to correct those things. This included the Home Mortgage Disclosure Act of 1975 that required the banks to collect data on which the person was that was the borrower as far as race. There was also the Community Reinvestment Act of 1977 against Red Lining.

When you are a lender, there are areas where you are not trying to be prejudice but you realize that an appraiser could literally get shot. Bruce is in the hard money business, and they get asked to go to certain areas to do loans; and all those things come into play that you are actually in danger. With Red Lining, the intent was not to have a prejudice outcome, which is just and fair; but you have to ask if it also takes away the ability to say no because you know it is not going to have a good outcome. The effect of all the various laws, provisions, and actions by regulators led banks and lenders to increasingly divorce the decision on whether or not to get the mortgage from hard realities of what lending is all about. At some point, in order to meet their Community Reinvestment Act targets, banks made loans they knew were going to be bad because they thought they had to do it to stay in business. The CRE Act originally required banks to make efforts to reach targeted populations but did not require that specific results be achieved. The Clinton Administration reinterpreted that law and rewrote the regulation regarding it in the mid-1990s and said that they actually had to show results. The Federal Reserve began to reject applications for mergers and opening branches to banks that did not have the Homeowner Disclosure Act data that was collected on lending by race, gender, and income. These steps taken by regulators had the effect of forcing banks to make bad loans. A common criticism against people who make claims that the CRE Act has an impact on lending is that it was passed in 1997 and the crisis was in the 2000s. The whole process was very gradual, and the idea of forcing banks to do lending against solid lending principles came into play in the mid 1990s. As each merger was made and came about in the years following 1995, the banks had to make a commitment to do a certain amount of CRE lending. By 2007, they had made commitments of over $4 trillion. If you go back to the mid 1990s, the CRE lending might be $50 billion inconsequential. In the end, it was trillions of dollars that the commitment had to be made.

There is a quote that states, “The GSE Act became the vehicle for putting forth the philosophical view that housing is the civil right,” which basically states that people are entitled to own a house. Major provisions of the act was written by a group of housing advocates and activists under an informal deputization by Henry Gonzales, who was the Chairman of the House Financial Services Committee in the early 1990s. These housing activists’ attorneys got together and crafted this language to achieve the goals and make housing more of a right and to impose that idea on lending. These are the same groups that are pointing out the loan programs and saying they were unfairly skewed to people of color and lesser income. They are now rewriting history and saying that lenders deliberately went out of the way to make bad loans, and therefore they are to blame instead of the rules, regulations, and laws. Because they were seemingly able to hide in the black box, not many people really understood the mandate underneath the covers that it was something Fannie and Freddie had to do. There was not much exposure to what was being proposed and put into law in the early 1990s. A lot of people thought it was just guaranteeing everyone equal access to credit and not steering it.

Tune in next week as Bruce and Robert England continue their discussion on the black box and real estate market

For more information about The Norris Group’s California hard money loans or our California Trust Deed investments, visit the website or call our office at 951-780-5856 for more information. For upcoming California real estate investor training and events, visit The Norris Group website and our California investor calendar. You’ll also find our award-winning real estate radio show on KTIE 590am at 6pm on Saturdays or you can listen to over 170 podcasts in our free investor radio archive.


Tags: Affordable Lending Goal, Alternative A, Black Box Casino, bruce norris, fannie mae, federal affordable housing provisions, Federal Housing Enterprise Financial Safety and Soundness Act, Federal Housing Finance Agency, FICO score, financial crisis, freddie mac, gse, GSE Act, HUD, Jim Lockhart, mortgage-backed security, political clout, Robert England, The Norris Group Real Estate Radio Show

Friday, December 16, 2011

Fannie Mae and Freddie Mac Pushed Rapid Credit Rescoring To Briefly Turn Subprime to Prime To Get Risky Loans Approved, Mortgage Broker Says

By Robert Stowe England
December 16, 2011

According to a former mortgage broker, members of Congress, Fannie Mae, Freddie Mac, and federal officials orchestrated and imposed on mortgage brokers and credit rating bureaus a policy to rapidly rescore consumer credit ratings so that more borrowers without reported incomes could get mortgages.

This coordinated effort enabled many subprime and nearly subprime borrowers to temporarily appear to be have credit scores high enough to be prime borrowers and, in the process, greatly expand lending in a period that stretched from 1998 to 2004.

“I'll bet 95% of the mortgages that went out of our office were subprime even if they weren't rated that way,” the broker said.

Mortgage brokers are wholesale lenders who originate their mortgages for large banks and other financial institutions.

“What infuriates me about when [President] Obama speaks or Barney Frank or anyone else who talks about these mortgage-backed securities and everything that happened, is that nobody knows the real truth about what goes on in the mortgage business and why it failed,” the broker said.

The broker’s claims, if substantiated, could mean that the true level of subprime and risky lending at Fannie and Freddie ahead of the 2008 financial crisis, was dramatically higher than the already high $1.8 trillion previously estimated to be on their books in mid-2008 by Ed Pinto, former chief credit officer for Fannie Mae.

Rapid credit rescoring was designed to get low credit scores up to the 700 credit score level where borrowers could qualify for existing programs at Fannie and Freddie that did not require any reported or stated income.

The broker, who described how the scheme worked in a call in to the Rush Limbaugh Show on December 7, identified herself only as “Laurie,” who said she had worked both as a packager of loans and an advertising executive for a mortgage brokerage firm.

Laurie said she did not want to identify herself because the broker had become involved with lawsuits over some of these practices.

The script of the conversation between Laurie and Limbaugh can be found at this link:

The pressure on mortgage brokers to engage in rapid credit rescoring came from the credit rating agencies, according to the broker. “We used to get visits by our credit representatives from the three major credit bureaus,” she said. “They were under a lot of pressure to develop a program to allow people to, quote, unquote, fix their credits faster,” she explained.

It was clear where the pressure on the bureaus originated. “According to the people from the credit managers bureaus, they were getting that pressure from Congress and [Federal Housing Administration or] FHA and Fannie and Freddie that they weren't doing enough to help people,” Laurie recalled.

Washington politicians and bureaucrats, in speaking to credit rating bureaus, belittled and ridiculed their rating practices. The credit bureaus were accused of “being unfair because they weren't doing enough to allow people who had had financial problems to fix their credit.”

Temporary Fix

The higher scores obtained through the rapid rescoring process usually proved to be fleeting.

The new higher credit score “wouldn't survive the next update from the credit bureau,” said Laurie. “The next time that update [from the credit bureau] came along, everything [that was detrimental to the borrower] was back on [the credit report], everything was like it was before,” she added.

Rapid credit rescoring was only available from mortgage brokers, Laurie said, and not for other consumer loans. In fact, sometimes people who knew about the availability of the rapid credit rescore would abuse that arrangement by going to a friendly mortgage broker to get a temporarily higher score to get a car loan, Laurie said.

The practice of rapid credit rescoring, in turn, made it possible for Fannie and Freddie to dramatically ramp up the volume of mortgage originations in the period from 1998 to 2004.

“When Fannie began this idea of packaging these things as securities and grouping them together, you'll find that the number of mortgage brokers for residential mortgages in the country skyrocketed,” Laurie said.

With Fannie and Freddie onboard the rapid credit rescoring process, new firms could quickly obtain lines of warehouse credit from banks to jump into the business of being mortgage originators.

The practice of rapid credit rescoring started out as a fairly benign. “It went from, yeah, maybe it took a long time to fix your credit to what we call the rapid rescore process,” Laurie said on the radio talk show.

Gradually, the practice turned toxic and fraudulent. “Our office could literally, in one day, take everybody's bad credit issues, write a one-line sentence about each one, fax it over to the credit bureau that . . . we paid to be members of, and, boom, within an hour, they were dropped off and the credit was rescored,” Laurie said on air.

The whole process became a sham. “It took literally less than 15 minutes at the end of the day,” said Laurie. “I mean we could fax it over and have it faxed back and rapid rescored.”

The growing band of mortgage brokers that joined the wholesale mortgage lending business would attend Fannie and Freddie seminars once or twice a year, according to Laurie.

“Fannie and Freddie were there, and they might as well have set up a carnival booth,” Laurie said. “I mean they were so excited about the fact that if you were a new mortgage business and you could get a wholesale line of credit, you could rapid rescore and qualify 500,000 people in a year, and they would back and buy everything you could send them.”

With the advent of rapid credit rescoring, the number of brokers employed by the business where Laurie was employed, was expanded from two to 20 brokers and the owner “sat in an office and did nothing but pull in wholesale lines of credit,” from such institutions as Washington Mutual, Laurie explained.

END

Tuesday, December 13, 2011

Could the 2008 Crash Have Been Prevented?

MortgageOrb Person of the Week: Robert Stowe England

Phil Hall of MortgageOrb writes December 13, 2011:

It has been more than three years since the September 2008 financial crisis, and many people are still trying to piece together what went so horribly wrong. Veteran financial journalist Robert Stowe England has offered his insight on what happened with his new book, "Black Box Casino: How Wall Street's Risky Shadow Banking Crashed Global Finance" (published by Praeger). MortgageOrb spoke with England about the circumstances that triggered the economic catastrophe.


Q: Was it possible that the 2008 financial crash could have been avoided? Or was this the financial services equivalent of a runaway train?

England: Both statements are true to some degree. There were so many vulnerabilities building up in the global financial system, it had, indeed, become a runaway train, while most did not yet realize that. Combine that with an ever-rising level of hidden bad credits and hidden bets and exposures, and a bad outcome was assured. In that sense, by 2005 or 2006, it was inevitable that we were headed for a train wreck. It was only a question of just how bad it was going to be.

There is a case to be made that certain actions could have prevented the coming crash from becoming the epic crisis it became. Admittedly, however, suggesting what might have been done to mitigate the expected outcome carries with it all the caveats one must make from hindsight bias.

Read more at this link

Monday, November 21, 2011

Black Box Casino Reveals Mad Max Follies of Crisis



Full Text Follows:


What Went Wrong

By Robert Stowe England


Remarks Made at a Book Signing at the Federal Street Gallery in Milton, Delaware

November 5, 2011


Good day.

My name is Robert Stowe England and I’m here today to shed a spotlight on the causes of the financial crisis of 2008.

If you are like me, when this crisis broke, you were shocked and outraged that things could get so out of hand and cause such an enormous calamity – the worst financial crisis of modern times.

Something had gone terribly wrong to deliver us into the world of Mad Max, where the norms we thought necessary for society have vanished. We saw financial institutions crashing all around us while authorities seemed powerless to do anything about it.

As a financial journalist, I covered the mortgage industry at the heart of the crisis. I was on the frontlines reporting a multitude of institutional and market failures that began to unfold early in 2007.

By August 2007, fully half the mortgage market had collapsed or had to be rescued. By September 2008, most of the rest of the mortgage market had to be salvaged by a government takeover of Fannie Mae and Freddie Mac.

As the bills for the crisis mount, the cost of bailing out Fannie and Freddie have been the biggest for taxpayers, nearly $175 billion so far. The final tally could rise to $380 billion, according to Washington estimates, or nearly $700 billion according to Standard & Poor’s.

At the time of the crisis, the mortgage market was probably the largest single largest financial market in the world at $11 trillion.

From the beginning, I found mortgage banking to be a fascinating, tough, and dynamic industry. Mortgage bankers sometimes had to be as vigilant and focused as fighter pilots in order to navigate the challenges they faced.

Those who took their eyes off the ball were dealt a swift and ruthless judgment by competitors and the markets.

Mortgage companies survived by being nimble and quick. They were able to double their capacity to originate loans in short order when necessary – or cut their capacity in half. The value of the assets mortgage bankers owned could be decimated falling interest rates. If you made bad loans, you had to buy them back from the investors and take the losses.

The markets ruled with a vengeance. It was not just Adam Smith’s famous invisible hand at work. It was more like an invisible fist.

It was my first year on the mortgage beat that I met and profiled Angelo Mozilo, co-founder of Countrywide Home Loans.

To interview Angelo, I went to the company’s headquarters in Pasadena, California. At 47, he was already known for his perpetual tan. The wide-ranging interviewed last 7 hours and included a tour of Countrywide’s growing collection of Hudson River Valley School landscape paintings.

Mozilo was the epitome of the dynamic mortgage market and Countrywide became the pacesetter and leader of the industry. He had passion for mortgage banking that suited the business.

By 2009, however, Angelo had become the chief villain of the financial crisis on the front page of the New York Times.

But something we terrible wrong. In the early 1990s virtually the entire mortgage market was made up of sound credits. By 2008, $4.7 trillion or nearly half of all mortgages outstanding were risky loans.

This huge volume of bad mortgage credits is at the root of the financial crisis.

The road to ruin for the mortgage market began in 1992 when Congress passed a law that established a regulatory framework for Fannie and Freddie. The short name for the law was the GSE Act. GSE is short for government-sponsored enterprise – a firm privately held by shareholders, but with a mission assigned by the government.

The GSE Act was supposed to assure that Fannie and Freddie would be operated in a safe and sound manner and not meet the same fate as the savings and loan industry, much of which failed in the 1980s.

Washington policy makers thought that turning mortgage loans into securities would avoid the problems of the savings and loans that held loans on their own books.

Fannie and Freddie would buy mortgages and pool them into a trust and issue mortgage-backed securities that Wall Street would sell to investors as AAA bonds – AAA because of the implicit guarantee of the federal government.

In theory, securitization was a good idea. But, the GSE Act created a set of rules riddled with flaws and Trojan horses that would bring about the downfall of the market.

For starters, under the GSE Act, the regulator for Fannie and Freddie was not an independent agency like the banking regulators but part of the Department of Housing and Urban Affairs or HUD.

Also under the GSE Act, Fannie and Freddie had a tiny capital base of 2.5 percent that could be quickly wiped out by losses. Well-capitalized banks by contrast have to have 10 percent capital.

Further, the regulator was not allowed to raise capital requirements if capital levels were deemed inadequate.

Also, Fannie and Freddie did not have to file quarterly reports with the Securities and Exchange Commission or SEC. They didn’t have to audit their financial statements.

They were allowed to lobby Congress.

They could hold securities on their balance sheet to boost profits and compensation for executives even though the whole point of their existence was to transfer that risk to investors.

The law governing Fannie and Freddie was part a new era in Washington where it became official government policy to push down lending standards to expand home ownership to lower income and minority households.

Over the years, as lending standards fell lower, mortgage origination volumes rose higher. Subprime and other risky loans took a steadily larger share and this flood of money into mortgages helped launch the housing bubble.

I warned way back in 1993 that trying to achieve equal outcomes for people with good credit and a good down payment and people with bad credit and little or no down payment was destined to cause grief and serious financial harm.

The GSE Act also set affordable housing goals for Fannie and Freddie to be set not by the regulator buy by the Department of Housing and Urban Development or HUD.

With Congress constantly applying the pressure, a sucession of HUD Secretaries from Henry Cisneros, Andrew Cuomo to Alphonso Jackson steadily raised the affordable housing goals.

For members of Congress, it was a political bonanza. They could take credit for benefits for constituents without having to go through the budgeting process, no matter that loans were made to people who could not pay them back.

In 1992, 30 percent of all mortgages acquired by the GSEs were aimed at low and moderate-income households. By 2008, the affordable housing goals required that 56 percent of all loans target that same population.

To meet these goals, lending standards had to steadily fall. In 1996, Fannie and Freddie ventured into 3 percent down payments. In 2000 they launched no down payment loans. They also ventured into subprime lending but mostly hid that activity by refusing to identify most of it as subprime.

In 2003 and 2004 Freddie and Fannie were caught up in huge accounting scandals. Leland Brendsel at the helm at Freddie and Franklin Raines at Fannie were found to have manipulated earnings to increase their compensation.

While both had to resign, Brendsel went quietly but Raines went out kicking and screaming. Neither paid any real penalty for their fraud. Brendsel, who had made $30,000 in campaign contributions the prior year, walked off with $24 million, while Raines hauled off $92 million.

The failure to hold Brendsel and Raines to account sent a dangerous signal, I think, to others who contemplated fraudulent schemes. Rewards could be huge and the potential downside limited.

Fannie and Freddie grow so large that by 2004, Fed Chairman Alan Greenspan worried that if one of them failed, it would pose systemic risk.

Fannie and Freddie, however, are only part of the story.

Wall Street came up with private label mortgage-backed securities to compete with Fannie and Freddie, including jumbo mortgages, Alt-A or low or no documentation loans, and subprime loans.

In 1995 HUD decreed that the GSEs could buy those private label securities to meet their ever-rising affordable housing goals. Former GSE regulator Jim Lockhart has said Fannie and Freddie could never have met those goals without buying the private label securities.

Fannie and Freddie and the private label originators fought for market share in a race to the bottom of the mortgage credit pool. With a pricing advantage, the GSEs took the stronger credit in the subprime market.

New and increasingly predatory loans appeared. There were interest only mortgages did not pay down the principal and resulted in huge jumps in payments after few years.

Just about anyone could qualify for no income no asset or loans. Then there were no income no job no asset loans.

It got to the point the mortgage brokers were scouting out illegal immigrants with menial jobs to give them loans even when the borrowers were not even thinking about buying a home.

In South San Francisco, a cleaning lady bought a house for $700,000 with no money down and walked away from the closing with $8,000 in cash. Shocked to learn how much each month’s payment would be, she and her husband moved out of the house after three weeks and never made a single payment.

What happened to the famed market discipline that rule the mortgage industry?

Beginning in 2002, Wall Street was having trouble selling the lower credit quality pieces or tranches of private label mortgage-backed securities to investors. These were rated A, BBB and BBB minus.

American institutional investors had stopped buying these lower-rated tranches that served as a buffer for losses for investors in the AAA bonds. Without buyers for the lower-rated bonds, the subprime private label market should have corrected – or even crashed.

However, Wall Street came up with the idea of taking all the lower credit pieces of subprime and other risky mortgage bonds and rolling them into collateralized debt obligations or CDOs.

Texas hedge fund manager Kyle Bass said it best when he called the subprime CDOs “the biggest bait and switch of all time.”

Wall Street was able to sell these assets to European and Asian buyers, who took the AAA rating as a seal of approval, without seriously questioning the process by which the credit rating agencies gave them such a rating.

These buyers of AAA CDO bonds had mountains of dollars from trade surpluses and recycled petro dollars and needed dollar investments. At a time of low interest rates, they couldn’t resist the higher premium offered by CDO bonds with AAA ratings. It seemed too good to be true. It was.

How could a bunch of bad credits rolled together create good credits? It was the financial equivalent of weaving flax into gold. Few seemed to question this improbable fairy tale that was justified with sophisticated computer models.

Even with willing buyers, the subprime CDO business faced another problem. No one really wanted the lower credit rated CDO tranches.

But, Wall Street firms came up with a solution. They would sell each other those lower tranches in order to generate the deals and earn the fees. Their gentlemen’s agreement was
“You buy my BBB tranches and I’ll buy yours.”

Often senior management at these firms did not understand the risk this posed – or did not want to know. All that mattered was that the deals were generating huge bonuses for everybody.

The creation of so many unloved lower-rated tranches of CDOs caught the eye of hedge funds who loved them because they were so bad.

Hedge funds wanted them at first because of their high returns, but later they decided to bet against them.

In time, hedge funds came to sponsor almost half of all CDOs. They would buy the equity piece of the deal for its super high premium while at the same time making much larger bets against lower rated tranches. They expected to get rich off the failure of the U.S. housing market.

Hedge funds were not supposed to choose the assets placed in CDOs – but evidence suggests strongly that they were able to influence those decisions to include more are more of the worst credits.

The demand from CDOs for weaker subprime credits – usually only a fraction of each deal – had a perverse effect. It greatly increased demand for mortgage lenders to increase the volume overall level of subprime and risky mortgages to supply the bonds needed for the CDOs.

In short, the subprime CDO business was poisoning the private label mortgage-backed securities business.

In an outcome James Bond villain Goldfinger would love, Wall Street was creating a flow of funds into the mortgage industry in search of bad credits.

Subprime mortgage originator Bill Dallas of Ownit opened a window into this world when he said Wall Street was paying him more to do a loan with poor underwriting than one with good underwriting.

Merrill Lynch and Citigroup were the kings of CDOs and bear much of the blame for the crisis.

Merrill’s chairman Stanley O’Neil made $91 million in 2006 while turbocharging the CDO business. A year later, Merrill had to take an $8.3 billion write-down and O’Neal was fired, walking away with another $151 million.

At Citigroup, it was Robert Rubin who talked chairman Chuck Prince into diving headlong into the CDO business. Citigroup hid the toxic assets it was creating in structured investment vehicles or SIVs off its balance sheet and in black boxes on its balance sheet.

In the first and second quarter of 2007, the company concealed the existence of $50 billion in subprime assets in its audited SEC filings.

Even though top officials are required to personally sign accounting statements and be held personally liable, the SEC did not investigate Prince or Rubin. The case was settled with minor fines to lower-level officials.

A whistleblower inside Citi named Richard Bowen tried to warn Rubin about the growing volume of bad mortgages feeding the CDO monster.

Bowen gave his warning in a memo to Rubin titled “URGENT—READ IMMEDIATELY,” all in capital letters. He told Rubin Citi could face billions in losses if investors demanded Citi repurchase defective loans.

When called before the Financial Crisis Inquiry Commission, Rubin was asked about the memo. His answer? “[E]ither I or somebody else, and I truly do not remember who, but either I or somebody else sent it to the appropriate people, and I do know factually that that was acted on promptly and actions were taken in response to it.”

Clearly nothing was done. Citi would have failed if Treasury, the FDIC and the Fed hadn’t put together $476 billion in TARP funds and guarantees against losses from bad mortgage assets.

Washington’s worst dereliction of duty was its failure to enforce the laws on the books that could have helped prevent or mitigate the crisis.

The SEC was the weakest link – mostly by Congressional design – but also because it was a lax enforcer of laws against fraud and market manipulation.

Take the case of the naked short sellers that brought down Bear Stearns. On March 11, 2008, an unidentified party made a $1.7 million bet through put options that Bear Stearns would collapse within 10 days.

At the same time, rumors were widely circulated that Bear Stearns was out of cash even though they had $18 billion on hand. Investment funds began to pull out their brokerage accounts. In only few short days, Bear Stearns was down to $2 billion in cash and on the verge of collapse.

More than ten million shares were sold into the market by “sellers” who did not own them or had not borrowed them, as required by law. This pushed Bear’s share price from $62 to $30.

Facing a sudden demise, Bear agreed to be sold to JPMorgan for $2 a share or $236 million, less than the value of its corporate headquarters. Meanwhile, the party who had place the $1.7 million bet made $271 million.

There was a SEC investigation of the naked short selling of Bear’s shares but not one was brought to justice.

While the collapse of Bears Stearns should have been a wake-up call to Chris Cox at the SEC and Hank Paulson at Treasury, no one took steps to prevent naked short selling from bringing down other investment banks as the market now expected.

Only six months later in September 2008, naked short sellers struck again. They sold tens of millions of Lehman Brothers’ shares they did not own or borrow. In a matter of days they forced the company into bankruptcy, precipitating the financial crisis of 2008.

The SEC won’t even say if there was an investigation of the Lehman naked short sales. No one has been brought to justice.

There is another painful lesson learned from the crisis. The architecture of financial system had grown far more rickety and vulnerable.

During 2007 and 2008, there were massive mostly hidden runs on both the shadow banking system and on regulated banks and investment banks.

It all began in August 2007, when a panic began in overnight funding contracts known as repurchase agreements or repos. Firms can obtain cash by selling their assets overnight and buying them back the next day for a tiny increase in price of those assets

The panic got underway on trading desks when the parties that provided overnight cash wanted additional collateral above and beyond the value of the cash. They were asking for a haircut on the value of the assets.

By the end of 2008, a steadily increasing haircuts drained more than a trillion dollars out of the banking system. It all happened out of the public eye.

There were other calamities. For example, a run on SIVs that funded by asset-backed commercial paper drained another $451 billion out of the system in late 2007.

Credit default swaps, a form of insurance against debts, brought more financial pain. Margin calls on the swaps began to drain funds from the system, bringing down the world’s largest insurance company AIG.

How did the financial get to be so weak? That is the question that I sought to answer. It was a monumental mystery that needed to be investigated and explained.

Not surprisingly, people central to the story did not want to talk. I learned that the fastest way to a dial tone was to call a Wall Street firm and ask to talk about subprime CDOs.

Progress was slow, but I managed to piece together the story.

Black Box Casino is a story about the one half of the world of banking that is shadow banking. It is the story of how huge swaths of that shadow banking and financial activity moved into black boxes.

Black boxes are financial institutions and vehicles with no transparency. You can’t see inside and know what bad assets might be hidden there. I discovered through my work, that some of these black boxes housed financial casinos where fast money and high stakes were the norm.

Black boxes can also conceal fraud. We would learn only after its failure, for example, that Lehman Brothers filed public disclosures that hid massive manipulation of accounting.

Mortgage bonds became attractive to market players who wanted to bet for or against them using credit default swaps.

Leading up to the crisis, more than $20 trillion in bets were made on credit assets not owned by those making the bets.

In the end, I learned the painful reality of the new financial world order.

The financial system had become more sophisticated and opaque and vastly more vulnerable.

If we are to address the weaknesses in the system, we first need to understand what went wrong.

For the most part, Washington has failed to that. In some cases Washington pols and officials have covered their eyes and ears and eyes to avoid seeing and hearing the truth.

I hope my book will be a contribution toward understanding what went wrong and I look forward to the efforts of others in this vital quest.

The American people – indeed, the people of the world – deserve honest answers.

END

Sunday, November 13, 2011

Rickards Says U.S. Making Same Mistakes As Japan


In an interview on Bloomberg TV November 10, James Rickards says that while the Fed is saying it does not want to repeat the mistakes of Japan, the Fed is, in fact, repeating the very same mistakes.

Rickards, senior managing director for Tangent Capital Partners, a merchant bank based in New York, is interviewed on Bloomberg's Money Moves with Deirdre Bolton.

Rickards has a new book, Currency Wars, that was released November 10, that focuses on the role of currency wars in modern history and the role the a gold standard has made and can make to provide the kind of stability that is needed for sustained growth.

Rickards criticizes the Fed for thinking that "they're playing with a thermostat" that they can dial up or dial down. However, they are, instead "playing with a nuclear reactor" with fuel rods. And, if they get it wrong, we can have "a massive meltdown." He sees the possibility of a lost decade in the United States as the best possible outcome, with the possibility things could be much, much worse.

James Grant is also interviewed in the same segment and he argues that academics and policy makers should seriously consider the gold standard.

Friday, November 11, 2011

Inside the Story of What Went Wrong

Remarks Made at a Book Party and Signing for Black Box Casino
Event Hosted at 3101 Chain Bridge Road, Washington, D.C. 20016

November 10, 2011

By Robert Stowe England

I’m here tonight to shine a spotlight on the causes of the financial crisis of 2008.

If you are like me, when this crisis broke, you were shocked and outraged.

Something had gone terribly wrong to deliver us into the world of Mad Max, where the norms vanished that we thought necessary to sustain our way of life.

Financial institutions were crashing all around us while authorities seemed powerless to do anything about it. It was the worst financial crisis of modern times.

As a journalist writing for Mortgage Banking magazine for more than 20 years, I covered the mortgage industry at the heart of the crisis.

In January 2007, I found myself on the frontlines of the crisis reporting on a multitude of institutional and market failures than were just beginning to get underway.

By August 2007, fully half the $11 trillion mortgage market had collapsed or had to be rescued. By September 2008, the government had to take over Fannie Mae and Freddie Mac to keep most of the rest of the market from collapsing.

As the bills for the crisis mount, the cost to taxpayers of bailing out Fannie and Freddie has been the biggest of any financial institution, nearly $184 billion so far. More losses lie ahead.

Few financial institutions have suffered so great a fall in reputation as have Fannie and Freddie. One insider put is this way: “The public’s view of us couldn’t get any worse. We’re somewhere just above or just below the Ebola virus.”

From the beginning, I found mortgage banking to be a fascinating, tough, and dynamic industry. Mortgage bankers sometimes had to be as vigilant and focused as fighter pilots in order to navigate the challenges they faced. Success could be fleeting as barriers to entry were low and, thus, new competitors could come out of nowhere and challenge your success. Companies had to be able to double in size or cut back half of capacity almost over night.

The markets ruled with a vengeance. It was not just Adam Smith’s famous invisible hand at work. It was more like an invisible fist.

It was my first year writing about the industry in 1988 that I traveled to Pasadena, California and I met and profiled Angelo Mozilo, co-founder of Countrywide Home Loans.

Mozilo personified the dynamic mortgage market and Countrywide became the pacesetter and leader of the industry. His “fire in the belly” suited the business.

By 2009, however, Angelo had become the chief villain of the financial crisis on the front page of the New York Times.

The industry went from being an exemplar of market discipline and good credits two decades ago to a generator of toxic assets. By 2008, $4.7 trillion, or nearly half of all mortgages outstanding, were risky loans.

This huge volume of bad mortgage credits is at the root of the financial crisis.

The road to the mortgage meltdown began in 1992 when Congress crafted a law to govern the regulation of Fannie and Freddie. The short name for the law is the GSE Act. A GSE is a government-sponsored enterprise – a firm owned by shareholders, but with a government mandated mission.

The provisions in the GSE Act was supposed to assure Fannie and Freddie would be operated in a safe and sound manner and not end up like the failed savings and loan industry.

Washington policy makers believed that turning mortgage loans into securities would avoid the problems of the savings and loans that held mortgages on their own books.

Fannie and Freddie would buy mortgages and pool them into a trust and issue mortgage-backed securities that Wall Street would sell to investors as AAA bonds – AAA because of the implicit guarantee of the federal government.

In theory, securitization was a good idea. Congress, however, did not capitalize on the potential market strengths of securitization when writing the GSE Act. Instead, they inserted Trojan horse provisions, as Ed Pinto calls them that would inevitably cause Fannie and Freddie to fail.

For starters, under the law, the GSE regulator for Fannie and Freddie was not an independent agency but located within the Department of Housing and Urban Affairs or HUD. Banking regulators, by contrast, are independent agencies.

Also under the GSE Act, Fannie and Freddie were required to have only a tiny capital base of 2.5 percent for loans and securities and 0.45 percent of guarantees. This capital could quickly be wiped out by losses. Well-capitalized banks by contrast have to have 10 percent capital.

Further, the regulator was not allowed to require the GSEs to raise their capital levels if they felt it was necessary to assure their safety and soundness.

Under the GSE Act, Fannie and Freddie did not have to file audited quarterly reports with the Securities and Exchange Commission or SEC.

They were allowed to lobby Congress, while they also had to go to Congress every year for funding.

They could hold securities on their balance sheet to boost profits and compensation for executives even though the whole point of their existence was to transfer that risk to investors.

The GSE Act was part of a new era in Washington where it became official government policy to push down lending standards to expand home ownership to lower income and minority households.

Congress gave HUD, not the GSE regulator, the power to set affordable housing goals for Fannie and Freddie.

A succession of HUD Secretaries from Henry Cisneros, to Andrew Cuomo to Alphonso Jackson steadily raised the affordable housing goals, often under pressure from Congress.

For Congress, steadily higher affordable housing goals proved to be a political bonanza. They could take credit for benefits for constituents without having to go through the budgeting process. It did not seem to matter to Congress that loans were made to people who could not pay them back.

In 1992, 30 percent of all mortgages acquired by the GSEs were aimed at low and moderate-income households, the broadest of the affordable housing goals. By 2008, this goal had been raised to 56 percent. The goal for low income households, which started at 11 percent, had reached an impossible 27 percent by 2008.

To meet these goals, lending standards and down payments had to steadily fall. As underwriting was loosened, mortgage funding volume expanded. The two GSEs grew so large, Fed Chairman Alan Greenspan began to worry they posed a risk to the financial system should one of them fail

In 2003 and 2004, accounting scandals were uncovered at Freddie and Fannie by the intrepid Armando Falcon, the GSEs chief regulator. Investigators found that Leland Brendsel at Freddie and Franklin Raines at Fannie had manipulated earnings to increase senior executive compensation.

Both had to resign but no one went to jail or paid a significant fine. Brendsel, who had made $30,000 in campaign contributions the prior year, walked off with $24 million, while Raines hauled off $92 million.

The failure to hold Brendsel and Raines to account sent a dangerous signal, I think, to others in the financial markets who contemplated fraudulent schemes.

Fannie and Freddie, however, are only part of the story.

Wall Street came up with private label mortgage-backed securities to compete with Fannie and Freddie, including subprime and Alternative-A or Alt-A, which are prime credit mortgages with low or no documentation of income and assets.

In 1995 HUD decreed that the GSEs could buy private label securities to meet their ever-rising affordable housing goals. Former GSE regulator Jim Lockhart has said Fannie and Freddie could never have met those goals without buying the private label securities.

Fannie and Freddie and the private label industry fought for market share in a race to the bottom of the mortgage credit pool.

New and increasingly predatory loans appeared. There were interest only mortgages where borrowers did not pay down the principal for three to seven years. Afterwards payments jumped so high, many borrowers could no longer afford the payment.

Just about anyone could qualify for a no income no job no asset mortgage or NINJA.

It got to the point that an illegal immigrant from Brazil who cleaned houses for a living and earned only $24,000 a year bought a house for $700,000 in South San Francisco with no money down and walked away from the closing with $8,000 in cash. She and her husband moved out of the house after three weeks and never made a single payment.

The famed market discipline that ruled the mortgage industry was gone. What happened?

The short answer – market discipline was subverted.

Beginning in 2002, Wall Street was having trouble selling investors the lower credit quality pieces or tranches of subprime private label mortgage-backed securities. These were the certificates rated A, BBB and BBB minus.

American institutional investors had wised up and stopped buying these lower-rated tranches that served as a buffer for losses for investors in the AAA bonds. Without buyers for the lower-rated bonds, the subprime private label market should have corrected.

However, Wall Street came up with the idea of taking all the lower credit pieces of subprime and other risky mortgage bonds and rolling them into collateralized debt obligations or CDOs.

Having no investor for the weakest subprime bonds, “We created the investor,” said Joseph Donovan at Credit Suisse in 2002. By that he meant they had created the CDO to be the investor and buy the lower-rated tranches of subprime mortgage bonds.

Texas hedge fund manager Kyle Bass called the subprime CDOs “the biggest bait and switch of all time.”

Wall Street was able to sell a lot of these assets to European and Asian buyers, who relied too much on the integrity of the AAA rating by the credit rating agencies.

Little did they understand the moral hazard of having credit rating agencies play a role in regulatory bank capital – an idea that came out of the Basel Committee for Banking Supervision in Switzerland, representing the world’s top central bankers.

Moody’s wrote to the Basel Committee in 2000 to told them not to urge nations to give credit agencies a regulatory role, warning it would lead those putting together deals to “shop” for ratings, undermining the process. Their warning was ignored. Their prophecy came true.

The buyers of AAA CDO bonds had mountains of dollars from trade surpluses and recycled petro dollars and needed dollar investments. At a time of low interest rates, they couldn’t resist the higher premium offered by CDO bonds with AAA ratings.

How could a bunch of bad credits rolled together create good a credit? It was the financial equivalent of weaving flax into gold. Yet, few questioned the sophisticated computer models that justified the ratings for these deals.

Even with willing buyers, the subprime CDO business faced another problem. No one really wanted the lowest rated tranches of the CDOs.

Wall Street came up with a solution to this, too. They would sell each other those lower tranches in order to generate the deals and earn the fees. There was a tacit agreement: “You buy my BBB tranches and I’ll buy yours.”

Often senior management at these firms did not seem understand the risk this posed. All that seemed to matter was that the deals were generating huge bonuses.

In time, hedge funds came to sponsor most of the CDOs because they liked the weaker subprime credits. They would buy the equity piece of the CDO deal for its super high premium while making much larger bets against lower rated tranches. By 2004, hedge funds were buying 80 percent of all equity tranches in subprime CDOs. After that, there was never enough supply to meet the hedge fund demand until the subprime CDO mania collapsed in mid-2007.

Hedge funds were not supposed to choose the assets placed in CDOs – but evidence suggests strongly that they were able to influence those decisions to include more and more of the worst subprime credits.

The demand for weaker subprime credits had a perverse effect. To generate the small piece of a subprime bond deal that goes into the CDO, a whole lot of subprime bonds had to be generated that were AAA. This was not too difficult as Fannie and Freddie steadily increased their demand for AAAs. To meet the demand generated by CDOs, mortgage lenders increased the overall level of subprime and risky mortgages.

In short, the subprime CDO business was poisoning the private label business and preventing it from responding to market signals.

In an outcome James Bond villain Goldfinger would love, Wall Street was creating a flow of funds into the mortgage industry in search of bad credits.

Merrill Lynch and Citigroup were the kings of CDOs and bear a great deal of the blame for the crisis.

Merrill’s chairman Stanley O’Neil made $91 million in 2006 while turbocharging the CDO business. A year later, Merrill had to take an $8.3 billion write-down and O’Neal was fired, walking away with $151 million.

At Citigroup, it was apparently Robert Rubin who talked chairman Chuck Prince into diving headlong into the CDO business. Citigroup hid the toxic assets it was creating in structured investment vehicles or SIVs off its balance sheet and in black boxes on its balance sheet.

In its audited filings with SEC for the first and second quarter of 2007, the company concealed the existence of more than $50 billion in subprime assets. When the bank owned up to it losses because failing SIVs forced them back onto the balance sheet, Prince resigned and walked away with $147 million. Rubin, who stayed on, had $50 million in compensation by the end of 2008.

Under the Sarbanes-Oxley Act, chief executives are required to sign accounting statements and be held personally liable. And yet, the SEC did not investigate Prince or Rubin or any other top official. The case was settled with minor fines to mid-level officials.

Citi stumbled toward collapse and would have failed except for a massive government intervention of $476 billion in guarantees from the FDIC, purchase and lending facilities from the Fed, and TARP funds from Treasury. More was done to save Citi than any other private financial institution.

Another cause of the crisis was Washington’s failure to enforce the laws on the books.

The SEC gained a reputation as an unsuccessful investigator and weak enforcer against fraud and market manipulation.

Take the case of the naked short sellers that brought down Bear Stearns. On March 11, 2008, an unidentified party made a $1.7 million bet through put options that Bear Stearns would collapse within 10 days.

At the same time, rumors were widely circulated that Bear Stearns was out of cash even though they had $18 billion on hand. Investment funds began to pull out their brokerage accounts. In only few short days, Bear Stearns was down to $2 billion in cash and on the verge of collapse.

More than ten million shares were sold into the market by “sellers” who did not own them or had not borrowed them, as required by law.

Out of options, Bear, whose share price a week earlier had been $62, agreed to be sold to JPMorgan Chase for $2 a share or $236 million, less than the value of its corporate headquarters. Meanwhile, the party who had place the $1.7 million bet pocketed even more money, $271 million.

There was a SEC investigation of the naked short selling of Bear’s shares but not one was brought to justice.

While the collapse of Bears Stearns should have been a wake-up call to Chris Cox at the SEC and Hank Paulson at Treasury, no one took steps to prevent naked short selling from bringing down other investment banks as the market now expected.

Only six months later in September 2008, naked short sellers struck again. They sold tens of millions of shares of Lehman Brothers they did not own or borrow. In a matter of days they forced the company into bankruptcy, precipitating the financial crisis of 2008.

None of the naked short sellers of Lehman shares have been brought to justice.

The build up of toxic assets and increase in market manipulation exposed the financial system’s rickety architecture. This, in turn, led to massive, often unseen runs on the financial system.

A panic began August 2007 in overnight funding contracts known as repurchase agreements or repos.

Counter parties that provided overnight cash wanted additional collateral above and beyond the value of the cash. They were asking for a haircut on the value of the assets.

By the end of 2008, ever-larger haircuts had drained as much as a trillion dollars out of the banking system.

There were other calamities. For example, a run on SIVs that funded by asset-backed commercial paper drained another $451 billion out of the system in late 2007, precipitating a crisis at Citigroup and causing the largest bankruptcy in Canada’s history.

Margin calls on credit default swaps added to market woes. Swaps, a form of shadow bond insurance, brought down the world’s largest insurance company AIG while the guy who ramped up the business, Joe Cassano, walked away with $300 million.

How did the financial system get to be so weak? That’s the question that perplexed me and so I started out to find the answers and tell the world what I found in a book.

Not surprisingly, people central to the story did not want to talk. I learned that the fastest way to a dial tone was to call a Wall Street firm and ask to talk about subprime CDOs. I did found many other sources, however, and pieced together the framework of the causes of the crisis.

Black Box Casino is a story about the one half of the world of banking that is shadow banking. It is the story of how huge swaths of financial activity moved into black boxes.

Black boxes are financial institutions and vehicles with no transparency. You can’t know what bad assets might be hidden there. Some of these black boxes housed financial casinos where activity was driven by fast money and high stakes and created huge risks for the financial system.

Black boxes can also conceal fraud. For example, Lehman Brothers filed public disclosures that hid massive manipulation of accounting.

In the biggest casino of all, the credit default swaps were the chips and the names of mortgage bonds were the numbered squares on the roulette table. More than $20 trillion in bets were made on credit assets not owned by those making the bets.

If we are to address the weaknesses in the system, we first need to understand what went wrong.

By and large, despite a great fanfare of good intentions, Washington has failed to do that.

I hope my book can make a contribution to a better understanding of what went wrong, the first step to setting things right. I also look forward to the findings of others studying the crisis.

The American people – indeed, the people of the world – deserve honest answers.

END

Wednesday, October 12, 2011

The Story of Writing Black Box Casino


Financial author Robert Stowe England tells the story of writing his new book, Black Box Casino, at the Mortgage Bankers Association 98th Annual Convention and Expo at the Hong Kong Room at the Hyatt Regency Hotel in downtown Chicago on October 10, 2011. The comments were followed by a book signing. The event was sponsored by Titan Lending, IDS, and Depth PR.

The story of writing the book was also told the following day, October 11, at Barnes & Noble's DePaul Center Bookstore in downtown Chicago at DePaul University's Loop Campus. That event, too, was followed by a book signing.

Read more about the book at this link:

Friday, October 7, 2011

Greenspan: Idea U.S. Banks Are Not Exposed to Troubled Euroepan Banks "An Inappropriate View"






"You can't understand the United States at all unless you understand what's going in Europe," Greenspan stated in an interview on CNBC's Squawk Box October 7, 2011.

"I think we have been through a remarkably elaborate program to try to find out whether the single currencies work," he said. Like others, Greenspan thought it would work in the beginning because the markets bought into the idea it would work. This could be seen in the pricing of the currencies in countries like Greece, Italy, Spain and Portugal as they moved toward currency union. As the date of currency union approached in each country, the spread in interest rates of local currencies above the German bund would narrow dramatically from a level of a hundreds of basis points.

"I said and thought the markets are assuming that the Greeks and the Italians and the Spaniards and Portuguese are going to behave like Germans, and that's what [the markets] were telling us," Greenspan said. "They were going to capture the basic culture of Germany of prudence and savings." Thus, Greenspan said, this is how he was persuaded by the markets.But, in fact, history has shown the opposite of what the markets were predicting. "I was wrong," he concluded.

"Does the Euro hold together?" he asked rhetorically. "Starting from scratch [Europe] would have been better off having a Euro-zone which included obviously Germany, Austria, Luxembourg, Finland, Netherlands," Greenspan said. "Obviously, that would have worked," Greenspan said. "In a sense that there is a common culture that goes across that part of Europe, and you can see it when you go from one place to the other."

Greenspan also raised the issue of how much exposure U.S. banks have to European banks. "Many U.S. banks say that they don't have exposure or that they hedged their exposure. Do you believe them?" Greenspan asked. "It's not a direct exposure. Look at their balance sheets, you can't find it. But we're dealing with a global market, and the notion that we are completely isolated is, I think, a very dangerous -- that's too strong a word -- it's an inappropriate view [given] the integration of these systems," he added.

"The presumption that somehow the huge American banking system or financial system is independent of Europe, I think, is just utterly unrealistic," Greenspan said. "It looks independent until it isn't."

Greenspan questioned whether enough has been done in Europe to address the crisis before it gets worse, pointing out that 2,000 basis points for interest rates in Greece above the German bund are not sustainable. There is no credible scenario of which I'm aware in which they can get by without very significant cuts in their sovereign debt."

No one in Europe is taking the kind of pro-active steps to get ahead of the inevitable crisis, according to Greenspan. "It's going to take time. We know that there is a 2,000 basis point spread. But no one's rushing over there to do anything immediately," he said. He points that in the United States, former Treasury Secretary Hank Paulson, if the same problem were facing America, "would do something or we would probably face that head on immediately because it's going to get worse if you don't," Greenspan said.

"But now, this is kind of the European way. They're going to let the banks sort of maybe recapitalize in the meantime and take their time," he said. "Suddenly, we have three up days in the dow. We're okay with the track that they're on, No? No."

The Dow is seeing equity premiums at 1930s levels, even though productivity is improving and earnings of non-financials moving higher, Greenspan pointed out. This indicates a level of worry in the U.S. stock market above and beyond the fundamentals of the American economy.

Saturday, October 1, 2011

George Bush Takes Up Clinton's Subprime Mantle in 2002 with Fannie, Freddie Minorities Initiative


This YouTube video is a recording of a RTL-Z Dutch television program of October 7, 2008. The Dutch news program plays an audio recording of President Bush in a speech in 2002 when he calls for increasing lending flexibility for blacks and Hispanics so that poor people "can have a house as nice as anybody else." He set a goal of 5.5 million new homes for minorities by 2010 to close the "homeownership gap" between whites and minorities. This was to be achieved he said, through new initiatives from Fannie Mae and Freddie Mac to make it easier for people with poor credit histories to qualify for a mortgage. President Clinton got the ball rolling and ramped up relaxed lending standards with a National Homeownership Strategy in 1995. As part of that, Fannie and Freddie introduced a raft of programs that made it easier for people with poor credit and little or no money down to obtain a mortgage.

Friday, September 16, 2011

Bernie Marcus Calls Dodd-Frank "Bonnie and Clyde" for Destroying Small Community Banks

Speaking on CNBC's Squawk Box, Bernie Marcus, co-founder of The Home Depot, blasts the regulations coming from the Dodd-Frank Act as "Bonnie and Clyde" because they are going to destroy small community banks. In the process, there will be no loans made to potential start-ups and the source of future jobs creation will be lost.

Monday, September 12, 2011

Harry Dent Sees Dow Crash to 3,000 in 2013


Harry Dent, founder and CEO of HS Dent, is author of a new book, The Great Crash Ahead. He sees an economic and market crash between 2012 to 2014. As baby boomers pay down a sizable chunk of $42 trillion in private debt in the United States to deleverage, this will be an ever growing deflationary force. Baby boomers around the world will start saving and stop driving up consumption. Because of this deleveraging, Dent warns that a debt crisis is coming back stronger than ever.

Dent does not believe that efforts of central banks to inflate and provide stimulus to the economic to counteract this trend will fail. "In the United States, we keep taking viagra and nothing much happens." He predicts gold will crash after rising to $2,000. Silver has already peaked, Dent said. The U.S. dollar's role as the safe haven currency will be strengthened. That is because, as private debt is paid off, it makes dollars more scarce, and it restores value to the dollar, he explains.

Sunday, August 21, 2011

ACORN Secretly Wrote 1992 Law That Set Fannie, Freddie 'On the Road to the Mortgage Meltdown'

The Association of Community Organizations for Reform Now (ACORN) was a key architect of a law passed in 1992 that set Fannie Mae and Freddie Mac on the road to ruin, according to a new book by Robert Stowe England to be released September 30 by Praeger.

The book, Black Box Casino, uncovers the myriad factors that led to the financial crisis of 2008, the worst financial implosion of modern times. This story is one of many threads woven into the book's narrative.

Read more about Black Box Casino at this link.

ACORN was a key leader in clandestine negotiations among housing activists to shape new legislation that would set into place the regulatory regime that governed Fannie and Freddie.

According to an affordable housing advocate familiar with what transpired at the meetings, ACORN and other housing groups were "informally deputized" (Black Box Casino, page 42) in 1992 to write key parts of new legislation by former House Banking Committee Chairman Henry Gonzalez, a Texas Democrat.

ACORN was co-founded in Arkansas in 1970 by Wade Rathke, a former member of the radical Students for a Democratic Society.

Once ACORN and other housing advocacy groups reached an agreement amongst themselves in secret negotiations in 1992, Gonzalez championed their agreement as his own in Congress, where the provisions were enacted into law.

The radical regulatory template that emerged from the housing advocates secret meetings became the centerpiece of the Federal Housing and Enterprises Safety and Soundness Act of 1992, or as it also known, the GSE Act. Fannie and Freddie are government-sponsored enterprises.

The idea for GSE legislation was originally proposed by the George H. W. Bush Administration and within Congress as a vehicle to ensure that Fannie and Freddie would not repeat the regulatory mistakes that led to the savings and loan crisis that cost taxpayers over $150 billion.

The original intent of the legislation was to establish a regime of prudential regulation and oversight to assure that the GSEs always operated in a safe and sound manner.

The goal of creating a prudential regulatory regime was superseded by provisions in the GSE Act that created ambitious affordable housing goals and a mechanism by which they could be constantly raised -- without any consideration of whether or not it would impact the safety and soundness of the GSEs.

ACORN and other housing groups had already scored a key victory in 1989 when they worked together behind the scenes in a similar fashion to craft the Community Investment Program provision in the Federal Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989.

The Community Investment Program provision in FIRREA requires members of the Federal Home Loan Banking System (about 7,500 banks today) to set aside a portion of their profits to finance "community investments," usually at below market rates of return.

The 1989 provision was viewed by ACORN as "tithing" by banks to support community projects. It was, in fact, an expropriation of profits and set into banking regulation the idea of politically-determined credit allocation schemes.

ACORN wanted to impose a similar "tithe" on Fannie and Freddie.

The Center for Community Change was behind the idea of having housing groups craft key provisions of the GSE Act, according to a housing advocate familiar with how the effort was organized. The center was founded in 1968 to honor Presidential hopeful Robert F. Kennedy, assassinated that year in Los Angeles by a Palestinian immigrant, Sirhan Sirhan, as he was campaigning for the Democratic nomination.

The Center for Community Change called on the National Low Income Housing Coalition to convene a working group of affordable housing advocates, which included ACORN and Consumers Union, as well as other participants from state governments and nonprofits involved in community development.

The coordinated effort had the advantage of getting all activist groups on the same page with a united front so they could more easily prevail over political opposition. It also assured that the debate would occur out of public sight and thus make it easier to enact radical positions that would not withstand public scrutiny.

The secret insider role was part of a dual insider/outsider strategy of the housing advocates and radicals (page 41), who would stage noisy and disruptive demonstrations and take over hearings to put public pressure on any opponents to their insider strategy.

A debate erupted among the housing groups between two distinct views of how national housing policy could benefit poor communities in deteriorating neighborhoods.

Gale Cincotta, a firebrand from Chicago, headed the National People's Alliance, which favored incorporating into law existing informal policies on affordable housing followed by Fannie and Freddie. GSE purchases of mortgages from low and moderate-income households represented 30 percent of their business. The GSEs also informally had adopted an overlapping goal of having 30 percent of their loan purchases be from disadvantaged urban areas. These two goals together were known as the 30/30 goals.

Cincotta won the debate over whether to pursue housing goals or ACORN's tithing approach. Cincotta was able to prevail in the debate because she had the backing of Fannie Mae and Freddie Mac (page 42.) Fannie Mae Chairman Jim Johnson had earlier decided to meet with the housing groups in order to shape the final legislation -- aware that the crafting of the bill was being outsourced.

ACORN had, by 1992, become a key part of the electoral strategy of the Democratic Party. Johnson, who hailed from Minnesota and who ran the failed Presidential bid of Walter Mondale in 1984, was politically connected and already had ties to ACORN.

Even so, ACORN, with a more radical view than either Cincotta or Johnson, was determined to create a scheme that would provide political incentives that would drive the level of affordable lending ever higher in perpetuity -- and do so by lowering mortgage lending standards.

After losing the tithing debate, ACORN wanted to add a third special affordable housing goal to the 30/30 goals. This third goal would be for very low income borrowers. This time, after a debate within the housing group, ACORN's view prevailed over Cincotta's. Fannie and Freddie agreed to pledge $3.5 billion in funds for the special affordable goal.


A Weak Prudential Regulator

The housing advocates also won a set of additional victories over how Fannie and Freddie would be regulated. For example, control over the housing goals was given to the Department of Housing and Urban Development (HUD). The goals regulator at HUD would have the authority to raise the affordable housing goals over time with no limit on how high they could go.

The prudential regulator for Fannie and Freddie had no say whatsoever in the housing goals, achieving another goal of the housing groups. That regulator, the Office of Federal Housing Enterprise Oversight or OFHEO, was placed within HUD under the new law. It was, thus, was not an independent regulator. Incredibly, Treasury Secretary Nicholas Brady also favored a regulator within HUD, while publicly saying he favored an independent regulator.

The housing advocates also scored with the decision that OFHEO's budget would be financed by Congressional appropriations and not by fees charged to Fannie and Freddie and forwarded to OFHEO. Other banking regulators are funded by fees from the banks that they regulate. Having to go hat in hand every year for new appropriations, OFHEO was, from the beginning, subject to political pressure from Congress to go easy on Fannie and Freddie.

Instead of guaranteeing safety and soundness for Fannie and Freddie, the GSE Act was a recipe for disaster.

Practically no one in Congress expressed any skepticism publicly about the intent and potential impact of the affordable housing goals. Many thought at the time the goals were there merely to insure equal lending standards for all, which was not its intent, according to Edward Pinto, former chief risk officer for Fannie Mae.

“They didn’t see the HUD affordable housing mission for what it was, to completely recast underwriting standards for the entire industry in an effort to spread wealth to get equal outcomes,” Pinto said (page 44).

Those who supported strong prudential regulation for Fannie and Freddie "were rolled," according to Pinto. "The way the bill got through [Congress] was the safety and soundness got watered down" and the affordable housing goals became the price paid for the weakened regulation, he said (page 44).

Fannie and Freddie were required to have only 2.5 percent capital against loans they held on their books. Banks with mortgages held on their balance sheet have to hold 8 percent capital against the mortgages. Further, Fannie and Freddie had to hold only 0.45 percent capital against the guarantees they issued for their mortgage-backed securities.

With these thin capital standards, the GSEs had a 40-to-1 leverage ratio for loans and a 222-to-1 leverage ratio for its guarantees. Depending on the mix of guarantees and loans, the overall leverage of the GSEs could rise dramatically. In 2008, the ratio approached 100 to 1. With leverage that high, modest losses could easily wipe out capital and require a taxpayer bailout.

Incredibly, the accounting standards employed by the GSEs were not like those of banks and other financial institutions. Instead, they were the generally accepted accounting principles or GAAP, which gave Fannie and Freddie more leeway to disguise losses.

The radical rationale behind the thin capital standards set by the GSE Act was inadvertently revealed by Massachusetts Congressman Barney Frank in September 2003, during hearings on OFHEO's finding of accounting fraud at Freddie Mac.

As some members of Congress pushed for stronger capital standards for Fannie and Freddie and the right of OFHHO to raise or lower those standards, Frank was vehemently opposed. "I do not want the same kind of focus on safety and soundness that we have" in the case of federal banking regulators, Frank said. "I want to roll the dice a little bit more in this situation towards subsidized housing," he added (page 73.)

This comment reveals that Frank and radical housing advocates defended the highly leveraged capital standards because such standards meant that Fannie and Freddie could engage in more affordable lending from a given capital base than they could with conventional and more prudent capital requirements.

Over time, a succession of HUD officials raised the goals during both the Clinton and George W. Bush Administrations.

The main goal for low and moderate-income borrowers reached 57 percent by 2008, nearly double its 1992 level. The special affordable goal for very low income households (ACORN's provision) reached 28 percent, more than double the 11 percent level of 1995, the first year it was set.

Thus, in effect, Fannie and Freddie expanded their overall lending by increasing the level of lending to households with the weakest of credit and the least amount of funds to put down for a purchase.

Along the way, Fannie and Freddie increased their level of risky lending but concealed the level of risk from public view by refusing to classify mortgages as subprime that were, in fact, made to borrowers with subprime credit (credit scores below 660).

Fannie and Freddie got into low and no documentation loans, as well as low down payment loans, too, increasing the risk on its books. In 1997, they launched their 3 percent downpayment mortgages and then moved to zero percent down payment mortgages in 2000.


$4.7 Trillion in Risky Mortgages

By mid 2008, on the eve of the financial crisis, Fannie and Freddie owned or guaranteed $1.8 trillion in risky mortgages, according to Pinto, who conducted a forensic study of the loan level information released by the GSEs after the government took over the GSEs and began to require them to release more data on the characteristics of Fannie and Freddie loans (page 62).

Other government programs, including the Federal Housing Administration, represented another $900 billion in risky loans. The government share of risky lending was, thus, $2.7 trillion on the eve of the crisis -- greater than the private sector mortgage-backed subprime and low-documentation mortgage securities, which stood at $1.9 trillion, according to Pinto.

By mid 2008, there was $4.6 trillion in risky mortgages in the $11 trillion mortgage market -- more than double the $1.9 million that markets recognized as risky. The housing market, which was dominated by prudent lending in the early 1990s had become a huge risky endeavor.

The GSEs had engaged in lending programs that were similar in risk to the reckless lending schemes that had emerged in the private sector, including no-income, no-asset (NINA) loans, as well as interest only (IO) loans.

Those risky assets were hidden because the GSE Act did not require Fannie and Freddie to file quarterly and annual reports with the Securities and Exchange Commission.

Fannie and Freddie, whose executives grew rich on the bonuses and salaries they earned as they drove down lending standards, were not prohibited from lobbying Congress in the GSE Act. They also were able to set up charitable organizations that could funnel money to ACORN and other allies.

The design of the GSE regulatory system by ACORN and other housing groups assured that Fannie and Freddie would lead a race to the bottom in lending standards. The regulatory regime also gave Fannie and Freddie such heavy political clout they could easily forestall any and all efforts at reform by Congress until they were on the verge of collapse.

"The GSE Act set Fannie and Freddie on the road to the mortgage meltdown," said Pinto (page 46).

Why would Johnson agree to such a regulatory regime during his negotiations with the housing groups that wrote the legislation? Fannie and Freddie thought they could capture the regulator (both HUD and OFHEO) and prevent the housing goals from rising so high they would threaten their existence, according to Pinto. But, in fact, Johnson and the GSEs in general, made a major political miscalculation.

So far, ACORN and other housing advocates have not revealed what they expected from the regulatory framework they largely wrote. Yet, regardless of what was intended, the GSE Act created a regulatory regime that Washington could not alter because of the perverse incentives the law put into place. It was a regime that would push affordable lending to ever higher and higher levels.

The vast expansion of mortgage lending by the GSEs and the inevitable and irresistible political pressure to raise the goals to ever higher and higher levels guaranteed that more and more funds would flow to ACORN and other housing groups, who helped lenders find borrowers to help them meet "affordable" housing goals.

Perversely, the same housing groups could also get funds to help borrowers having trouble making their mortgage payments. ACORN, thus, gained revenue streams no matter what happened to the loans.

In the end, the GSE Act turned out to be a "suicide pact" for Fannie and Freddie (page 73) -- one that would make a lot of politically-connected executives at the two firms very wealthy along the way.

The mountain of risky loans engendered by the GSE Act's regulatory regime helped build the housing bubble and spread risky assets across the globe through the sale of Fannie and Freddie securities, helping to set the stage for the financial crisis of 2008.

-- Robert Stowe England