Happy September; Welcome Back to Work!!

Private Label Securities, Redux

In last week’s blog, I noted that Fannie’s and Freddie’s regulator, the Federal Housing Finance Agency (FHFA) took a surprising stand and wrote 64 issuers or guarantors of private label subprime securities (PLS) sold to Fannie and Freddie, and urged them to pay their GSE debts.

Because of haphazard and shoddy underwriting on most of the underlying loans, as well as the application of spurious ratings and useless self-guarantees, the PLS mortgage bonds quickly went sour costing the GSEs billions.

Fannie and Freddie, as well as their regulator, are trying to make those businesses pay their bills, allowing the GSEs--in turn—to repay billions to the federal government.

Current estimates are that the subprime mess and resulting financial debacle cost more that $1.5 Trillion. That numbers doesn’t take into consideration the ruined lives, fortunes, aspirations, and careers of millions of people around the world.

In retrospect, a fair question to ask is, “Who was regulating these institutions when they fabricated and sold these soon to be worthless securities to the GSEs and others?”

The questionable credit quality of subprime loans was enough of an industry concern that some at Fannie (noted in post facto New York Times and Washington Post news stories) argued—unsuccessfully--against the purchases.

Aren’t the federal financial regulators supposed to be as aware as or smarter than the institutions they regulate?

For some (many?) of these financial services miscreants, using brokers to originate loans, securitizing pools of mortgages with their own corporate guarantees, and hedging them with exotic credit default swap contracts was a new business.

Did any federal government official check to see if these companies were up to the task and approve their undertakings?

Youth May Be Wasted on the Young, But Not With This Kid!


John McLeod, Canadian poet and a most proficient writer for “Housing Doom” (people who think I’m a cynic should read John and the very excellent HD blog), alerted me to a superb and insightful collegiate thesis, written last year by an undergraduate student working on her Harvard Economics degree with honors.

Anna Katherine Barnett-Hart’s 2009 paper is trenchant (certainly the first 33 pages are, until she gets very technical with her mathematical support/analysis), especially if one is seeking insight into why and how the massive production of subprime securitization started, mushroomed, and yielded so much financial destruction.

www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf


There always had been some systemic “subprime” financing, usually mortgage lenders—working in poor neighborhoods--overcharging less credit worthy borrowers for mortgages and reaping gains on loans that didn’t fit basic standards. But the amounts were miniscule compared to what began coming from Wall Street beginning in 2004 in the form of Collateralized Debt Obligations (CDOs), a descriptive category into which all mortgage backed securities generically fit.

This young author nailed the history, the principals and the abuse of subprime financing and securitization. She notes when Wall Street pioneers set it up, how they did it, the absolute profit whirlwind of profits, and why the practioners got engulfed by the surging investor demand for high yielding but risky mortgage securities. Hint: greed!

As the revenues rolled in everywhere, the suddenly monstrous US and international PLS appetite seemed to blind everyone involved to quality control or prudent underwriting concerns.

Early success drove the Wall Street firms and large banks to quickly originate great volumes of questionable mortgage product; securitizing it and busting the mortgage backed securities (MBS) into more exotic marketable “tranches;” and selling those bonds with abandon, often taking the riskiest products in house on their own balance sheets (Merrill and Lehman).

The three major credit rating agencies—relying on outdated and flawed models and metrics—affixed superior ratings on the bonds, a key element for the desired world wide acceptance. (For more on the rating agency breakdown, see Gretchen Morgenstern’s column in the September 5, NYT Business section.)

Moody’s S&P, and Fitch got overwhelmed with the subprime volume but continued to throw AAA ratings (the minimum investment grade required by many international financial regulators) on the senior security pieces. The raters were making historic profits and were gulled by the guarantor’s promises that they could pay for any shortfall.

From 2005 to 2007, ignoring history and prudence, few in the business believed the bottom would/could fall out of the residential real estate market and all the Street players figuratively became residents of New Orleans, singing, “Laissez les bons temps rouler.”

Yes, I know that Fannie and Freddie joined the feeding frenzy and bought the stuff, like hundreds of other financial institutions around the world. But, the GSEs didn’t create it, they didn’t cultivate it, package it, fashion “synthetic” PLS geometric enhancements from it, or sell it to institutional naifs/d.f bz; on street corners.

Who Dropped the Ball?


Just because the Fed, the Comptroller, the OTS, FDIC, and the SEC missed it—or maybe because they did--the GSE regulator, the Office of Federal Housing Oversight (OFHEO now FHFA), permitted Fannie and Freddie to buy those questionable mortgage securities.

As noted by the media in after-the-fact stories, folks inside Fannie/Freddie opposed those investments and said so to their superiors. Did anyone at OFHEO/FHFA feel similarly and, if so, did they tell anyone at either company?

Or was this another giant incident of Bush era regulators asleep at the switch or just being generally indifferent. If so, that’s very damaging and expensive indifference.

Lessons for All

Lesson for Obama White House and Congress: You can create all of the new financial regulatory units you will, but make sure they are staffed by people up to the job.

(Is now the time to make the pitch for Elizabeth Warren to head the new Consumer Office?)

Lesson for the GOP and GSE haters: Read this paper and see if you still can sustain the myth, “It all was Fannie's and Freddie’s fault.”

I know it will be inconvenient for you on the Right to budge from your simplistic talking points because you feel you have “facts” backing you up and because the GSE names are so cute and lend themselves to hyperbole or sounding like an insider.

But any objective observer can see the devastation that subprime—brought to us by the big banks and the Street—wreaked on Fannie, Freddie and many others and should be able to draw fairly stark distinctions between that activity and the GSEs traditional affordable housing support.

Stated simply, the GSE’s affordable housing mission, even when jacked up by President Clinton and President George W. Bush to more than half of their business volumes, with the active support of both congressional parties, didn’t tank the companies. It was the deviance from mission and their subprime purchases which shattered them, at least in Fannie’s case.

The other thing which could disturb some conservatives—if they are honest--is that when they scratch the surface of the subprime phenomenon they are going to find a lot of traditional GOP business interests feeding at that trough.

Read Ms. Barnett-Hart’s paper and see if her details square with your understanding of what happened and which financial interests were the culprits?

If Congress plans to redesign the nation’s mortgage finance system, both parties need to understand what they are changing and the recent history of it.


Spencer Bachus (R-Ala.)

Poor Mr. B, if the GOP recaptures the House in November, the smart money in town doesn’t like his chances of winding up chairing the House Financial Services Committee in 2011, despite the fact that he’s the current ranking minority Member.

When I lobbied, I always liked Bachus, because he was approachable and seemed willing to learn issues with which he wasn’t the most familiar. But for too many R’s, he has somehow become “Gomer Stumblebum” in the job and they want someone sharper heading their Financial Services committee.

The two names one hears are New Jersey’s Scott Garrett and Texan Jed Hensearling, although Michigan “Tea Partier” Michelle Bachman might try and leverage her Caucus popularity into the post.

The smartest of the possibilities is Garrett—by a wide margin--but brains don’t count for much insider the House GOP Caucus (or in the D Caucus, either). Bachus could prevail, if he has successfully raised thousands of dollars for his Financial Services colleagues and used his clout to get them re-elected. Expect a showdown, if the R’s win in November.




Maloni, 9-6-2010