THE CURMUDGEON CHRONICLE ©
AN IRREVERENT VIEW
Time Line: November 8, 2007
Date Line: Flemington New Jersey
The US economic hen house is full of chickens coming home to roost. No single sector of the economy is free of ills and no sector can mend what it has broken. The individuals and companies embroiled in the mess look askance when taken to task. They shrug and say, “The other guy must be responsible. I was just trying to make a profit.” In fact that is the sad but inescapable truth. The builders, banks, brokers, and rating agencies are in the headlines and at the storm center, so let’s look at them.
If you make a lot of one thing you can do it cheaper than if you make a variety of things to order. You can standardize production, reduce labor costs and get discounts for mass purchasing. One builder did just that, and built an entire community in North Carolina. About 1,000 houses were built and sold for $90,000 each; placed on tiny lots, and with few amenities. Today 41% of the houses are in foreclosure. As a matter of interest, the historic default rate in North Carolina is less than 3%.
How did that happen? Perhaps because the builder arranged the mortgages as part of the package offered. In one (typical) case, the buyer was a single mother whose sole income came from her job in a gas station where she earned $8.65 an hour. She got a 108% loan to cover the purchase price and closing costs, and defaulted within 90 days of closing title to the house.
The builder’s stock has declined from $72.00 per share to $8.00. It is being investigated by the SEC and is litigating with its bondholders. This company is not a fly-by-night. It has been around for over 35 years and had a decent reputation, yet it became a facilitator of or the sub-prime debacle, a problem that should not have happened but did in fact come to pass.
The fault lies in our banking and securities distribution system; in the training and culture of our executives; the attitude of business to the consumers of their products, and the use of the “American Dream” to subvert the dreams of Americans.
Let’s follow the path of that single mother’s loan. It couldn’t be kept by the bank that funded the mortgage. That would tie up the capital of the institution and limit its ability to re-use those dollars. The loan was bundled with a lot of other loans and “securitized”, i.e., turned into an asset that could be resold to long term investors like pension funds who seek assured revenue streams.
It was labeled “sub-prime”, but since it was part of a large pool of similar debt, all the loans in the pool were upgraded to a better credit rating than any single loan would have on its own. (Why that makes sense is beyond the ken of people who understand arithmetic.)
The Pension Funds have rules: they require assurance that the assets they buy are of acceptable quality and will provide the yield they seek. Fair enough, and if they can’t make that determination on their own: a disinterested third party must do it for them. (If you think something smells bad, but you would like to buy it anyway, find a shield to hide behind that will approve the deal.)
Enter the Rating Agencies who evaluate the securities and assign them an investment grade. If it is an acceptable grade, then the banks and brokers can acquire, package and sell the “securitized loans” to pension funds, mutual funds, institutional investors and maybe even to people like you and me in some guise or other. The Rating Agencies almost uniformly said the securitized sub-prime loans were investment grade.
We were off to the races!
The banks and brokers fought for the privilege of funding builders and developers; issuing the mortgages, packaging them and selling the packages. The proceeds showed substantial gains, added servicing revenues, and built the quarterly earnings. Everyone was having a great time until one day, the Rating Agencies figured out that they had certain conflicts of interest, (and substantial liabilities to boot), looking them I the face. They did the only reasonable thing from their point of view. They rated the securitized loans below investment grade, which is what they had always been I fact, and the storm broke.
It did not matter that there had been no material defaults. The law says the Pension Funds cannot own those securities. They turned to the people they bought the securities from and asked to be taken out of their positions. The banks and brokers are faced with an enormous problem. They can’t buy the securities back; they can’t sell the deals they currently own and are packaging, and there is no way in the world that anyone is going to step up to the plate to solve the problem.
There just is not that much money in the system. I think this is a Two Trillion Dollar bust by the time the dust settles. caused by greed, carelessness and indifference, teamed with a lack of governmental and corporate oversight.
There are parallels to draw between the current set of abuses and the events of the 1920’s ad 1930’s that led to bank collapses. The Banking Act of 1933 (the 2nd Glass-Steagall Act) was adopted to separate the functions of the banks and the securities industry and assure against possible abuses that we find in the sub-prime debacle. For sixty-six years we had a stable and powerful banking segment and a securities distribution system that became the yardstick for the world.
The legislation was deemed too restrictive by the banks and for years they lobbied for its repeal. Finally in 1999, the 2nd Glass Steagall Acts were repealed. The result has been substantial elimination of the local banking sector; a diminution of oversight, and the creation of a breeding ground for greed and inflated securities “values”.
What can you do if you are a bank that wants to grow in a tough environment? It is difficult to: find the deal; structure it; sell it to your customers; maximize your profits; be competitive, and still be selective enough to eliminate risk to the customer.
Among by-products of the desire for growth we have seen failure in various modes: the research departments of banks and brokers touting companies that they are trying to get as customers; phony bids for blocks of securities; failure to exercise diligence if it means loss of deposits and banking business, a la Parmalat, World Com etc.
The repeal of the 1933 Acts removed a barrier to self dealing and led to acquisitions that contributed to the current situation. If the Glass-Steagall Act was still in force, commercial banks would not own brokerage companies, mortgage companies or have been distributors of sub-prime paper.
Brokerage firms alone could not have generated the amount of mortgage debt that must now be dealt with. A banking system not participating in the scheme would not have approved buying in bulk what it would not buy individually.
I have no sympathy for people who borrow money they know they cannot repay. I have no sympathy for corporate greed that puts our country at economic risk. I have no sympathy for those who cause problems and then wring their hands and look for our tax dollars to bail them out.
My sympathy lays with the people whose pensions and savings have been lost or damaged; with the children who won’t go to college because the mutual fund that was so safe was in fact not safe at all. The chickens that have come home to roost make a bitter kind of soup; one which will be eaten with great gusto by the vultures that will lick clean the bones of sub-prime debt.
Howard Stamer
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