Sunday, January 11, 2009

financial reading

One silver lining from the current financial meltdown: It’s a sure bet we eventually are going to get some great books out of it. Better than Barbarians at the Gates about the Reagan-era leveraged buy-outs. Better even than Roger Lowenstein’s outstanding When Genius Failed about the how the hedge fund Long Term Capital Management almost brought down the global financial system. We’ve already gotten to the stage where we are seeing some good, long pieces in The New Yorker and Vanity Fair or serialized in places like the New York Times and Washington Post.

Here are a few from recent weeks.

The new Vanity Fair has a good (long) piece (“
Fannie Mae’s Last Stand”) on Fannie Mae and Freddie Mac, the so-called “Government Sponsored Enterprises” (GSEs). As you would expect from Vanity Fair, it focuses on the personalities and the politics more than the economics. During the campaign, Republicans tried to blame the whole financial meltdown on the GSEs and Democratic support for these entities. According to this narrative, it was basically poor minorities (surprise!) that caused our financial crisis. I kept intending to write the comprehensive post refuting that nonsense. At some point, especially after the election, it seemed moot. But in hardcore right-wing circles (like the 24% of the population that still approves of Bush’s job performance) it has become a firmly entrenched mythology that will endure beyond the graves of its current adherents to confuse the world view of generations of right-wingers to come. For that reason, I still might get around to writing that post one of these days. (In the meantime, if you want to dig into it a bit more yourself, you can read here, here and here.) But the Vanity Fair piece at least does a good job describing the politics and players behind the GSEs. (The right-wing narrative isn’t helped by the fact that lobbyists and “consultants” for Fannie and Freddie include John McCain’s campaign manager, Rick Davis, who had served as the president of the Homeownership Alliance, an advocacy group for the GSEs, right-wing godfather Grover Norquist, Newt Gingrich, and the original leader of the Christian Coalition, Ralph Reed.)

One concluding bit:

But a few things are clear. One is that the argument that Fannie and Freddie caused our entire economic calamity is absurd. Yes, the volume of bad mortgages that Fannie and Freddie bought may have blown the bubble bigger than it otherwise would have been. But to put the blame entirely on Fannie and Freddie is to exempt all the other players, including the mortgage originators who sold subprime mortgages and Wall Street, which packaged up the bad mortgages and sold them to investors around the globe.

Another thing that’s clear is that the critics were both right and very wrong about
Fannie and Freddie. Yes, their executives and shareholders made fortunes in the
glory years, and, yes, taxpayers are now bearing the brunt of whatever losses
there are. Just as critics always warned, it’s “the privatization of profits and the socialization of risks.” But what the critics missed is that that wasn’t unique to Fannie and Freddie. It turns out our entire financial sector was operating under that same premise—and to a far greater degree than Fannie and Freddie.

In the pantheon of right-wing demonology, Massachusetts Congressman Barney Frank, chairman of the House Financial Services Committee, has a special place – and only in part because he was the first openly gay member of Congress. Jeffrey Toobin has a good piece (“
Barney’s Great Adventure”) in the latest New Yorker.

Barney was sort-of a law school classmate of mine (he graduated the same year I started). He was 36-years-old at the time, which made him seem like an old man to those of us fresh out of college. He was already a major figure in Massachusetts politics, even then. He is one of the smartest, funniest (if not necessarily most congenial) people you will ever meet. (My favorite recent line, in response to Obama’s statement that we only have one president at a time: "I'm afraid that overstates the number”.) As Toobin writes, “In a 2006 poll of Capitol Hill staffers by Washingtonian, published shortly before the elections that gave Democrats control of the House for the first time in twelve years, Frank was voted the brainiest, funniest, and most eloquent congressman—a notable achievement, since he often speaks in a barely comprehensible mumble.”

In line with the Vanity Fair article, here is a bit from the Frank piece on the topic of Fannie and Freddie:
… Frank pointed out that when [conservative Congressman Scott] Garrett [R-NJ] had attempted to tighten regulations on Fannie and Freddie, Republicans had controlled the House. “Had a Republican majority been in favor of passing that bill, they would have done it,” Frank said. “Now he has claimed that it was we Democrats—myself—who blocked things. The number of occasions on which either Newt Gingrich or Tom DeLay consulted me about the specifics of legislation are far fewer than the gentleman from New Jersey seems to think.

“I will acknowledge that during the twelve years of Republican rule I was unable to stop them from impeaching Bill Clinton,” Frank went on. “I was unable to stop them from interfering in Terri Schiavo’s husband’s affairs. I was unable to stop their irresponsible tax cuts, the war in Iraq, and a Patriot Act that did not include civil liberties.” In other words, Frank insisted, if the Republicans had wanted to try to prevent the mortgage crisis, they would have had plenty of opportunities to do so.

… Frank went on, “In 2004, it was Bush who started to push Fannie and Freddie into subprime mortgages, because they were boasting about how they were expanding
homeownership for low-income people. And I said at the time, ‘Hey—(a) this is
going to jeopardize their profitability, but (b) it’s going to put people in homes they can’t afford, and they’re gonna lose them.’ ” (In a recent op-ed piece in the Wall Street Journal, Lawrence B. Lindsey, a former economic adviser to President Bush, wrote that Frank “is the only politician I know who has argued that we needed tighter rules that intentionally produce fewer homeowners and more renters.”) Frank recalled with disdain a Bush Administration proposal to allow time limits on rental vouchers for poor people. “They said, ‘Well, don’t you agree that we should limit the amount of time people have a voucher?’ I said, ‘Yes, if you limit the amount of time they can be poor—“I’m sorry, you can only be poor for four years.” ’ ”

In 2005, while the Democrats were still in the minority, Frank contributed to a bipartisan effort to put his objectives—tighter regulation of Fannie and Freddie and new funds for rental housing—into law. At the time, Fannie and Freddie were regulated by a small agency within the Department of Housing and Urban Development; the bill proposed to create an independent agency to monitor their operations. Frank and Michael Oxley, who was then chairman of the Financial Services Committee, achieved broad bipartisan support for the bill in the committee, and it passed the House. But the Senate never voted on the measure, in part because President Bush was likely to veto it. “If it had passed, that would have been one of the ways we could have reined in the bowling ball going downhill called housing,” Oxley told me. “Barney, to some extent, is misunderstood—with this image of him as a fierce partisan. He is an institutionalist. He believes in the House and in the process. He eschews the grandstanding style that so many members use and prefers to work behind the scenes and get something done.”

Frank’s prescience on the housing crisis should not be overstated, because Fannie and Freddie represented only one aspect of the problem. “Fannie and Freddie were contributors to the bubble, but they came late in the really bad loans, after the private issuers like Merrill and Citigroup,” Dean Baker, the co-director of the Center for Economic and Policy Research, in Washington, said. “The law probably would have curtailed their lending, but it’s hard to say it would have made any difference.
The real problem was outside of Fannie and Freddie, with the banks, and nobody
in Congress was talking about it.” …

Fannie and Freddie got into the subprime mess late in the game – pretty much at its peak – primarily because it was hemorrhaging market share to the Wall Street banks that were buying up junk from the likes of Countrywide, Indy Mac, WaMu and Lending Tree and packaging them into toxic securities. Indeed, the term “subprime” originally referred to those mortgage loans that did not qualify for resale to Fannie Mae. Although the GSEs held something like 60% of all US mortgages at their peak, they only held around 20% of the subprime junk (none of which they originated).

To get an idea how lax lending standards got, read
this episode dealing with WaMu, from the New York Times series “The Reckoning.” It’s filled with anecdotes, but here’s the gist:
On a financial landscape littered with wreckage, WaMu, a Seattle-based bank that opened branches at a clip worthy of a fast-food chain, stands out as a singularly brazen case of lax lending. By the first half of this year [2008], the value of its bad loans had reached $11.5 billion, nearly tripling from $4.2 billion a year earlier.

Interviews with two dozen former employees, mortgage brokers, real estate agents and appraisers reveal the relentless pressure to churn out loans that produced such results. …

During [former CEO Kerry] Killinger’s tenure, WaMu pressed sales agents to pump out loans while disregarding borrowers’ incomes and assets, according to former employees. The bank set up what insiders described as a system of dubious legality that enabled real estate agents to collect fees of more than $10,000 for bringing in borrowers, sometimes making the agents more beholden to WaMu than they were to their clients.

WaMu gave mortgage brokers handsome commissions for selling the riskiest loans, which carried higher fees, bolstering profits and ultimately the compensation of the
bank’s executives. WaMu pressured appraisers to provide inflated property values
that made loans appear less risky, enabling Wall Street to bundle them more easily for sale to investors.

“It was the Wild West,” said Steven M. Knobel, a founder of an appraisal company, Mitchell, Maxwell & Jackson, that did business with WaMu until 2007. “If you were alive, they would give you a loan. Actually, I think if you were dead, they would still give you a loan.” …

Revenue at WaMu’s home-lending unit swelled from $707 million in 2002 to almost $2 billion the following year, when the “The Power of Yes” campaign started.

Between 2000 and 2003, WaMu’s retail branches grew 70 percent, reaching 2,200 across 38 states, as the bank used an image of cheeky irreverence to attract new customers. In offbeat television ads, casually dressed WaMu employees ridiculed staid bankers in suits. …

For WaMu, variable-rate loans — option ARMs, in particular — were especially
attractive because they carried higher fees than other loans, and allowed WaMu
to book profits on interest payments that borrowers deferred. Because WaMu was
selling many of its loans to investors, it did not worry about defaults: by the time loans went bad, they were often in other hands.

WaMu’s adjustable-rate mortgages expanded from about one-fourth of new home loans in 2003 to 70 percent by 2006. …

If the financial crisis was limited to subprime mortgage loans, it would have been easy to contain. But what caused it to infect the entire global financial system was the hundreds of trillions of dollars (in nominal value) of derivatives of all kinds, particularly “credit default swaps” which created almost infinite leverage and tied all the financial institutions of the world together in ways that no one really understood. That, in turn, resulted in a complete breakdown of trust in the system as no one knew where the ultimate risk of all these trades resided.

The Washington Post had an excellent three-part series on the insurance giant AIG, whose bailout has already cost taxpayers $152 billion. It became “too big to fail” as it cranked out hundreds of billions of dollars worth of unregulated derivates. Highly recommended.

Part one: “
The Beautiful Machine”:
They would create an elegant and powerful system that earned billions of dollars, operating in the seams and gaps of the market and federal regulation. They and their firm would alter the way Wall Street did business, particularly in the use of derivatives, and eventually test Washington's growing belief that capitalism could safely thrive with little oversight.

Then, they would watch in disbelief as their creation -- by then in the hands of others -- led to the most costly rescue of a private company in U.S. history, triggering a federal investigation into AIG's near-collapse and making AIG synonymous not with safety and security, but with risk and ruin.

Over the past two decades, their enterprise, AIG Financial Products, evolved into an indispensable aid to such investment banks as Goldman Sachs and Merrill Lynch, as well as governments, municipalities and corporations around the world. The firm
developed innovative solutions for its clients, including new methods to free up cash, get rid of debt and guard against rising interest rates or currency fluctuations.

Financial Products unleashed techniques that others on Wall Street rushed to emulate, creating vast, interlocking deals that bound together financial institutions in ways that no one fully understood and contributed to the demise of its parent company as a private enterprise. In the panic of mid-September's crash, the Bush administration said that AIG had grown too intertwined with the global economy to fail and made the extraordinary decision to take over the reeling giant. The bailout stands at $152 billion and counting -- almost 10 times as large as the rescue for the American auto industry.

Many of the most compelling aspects of the economic cataclysm can be seen through the story of AIG and its Financial Products unit: the failure of credit-rating firms, the absence of meaningful federal regulation, the mistaken belief that private contracts did not pose systemic risk, the veneration of computer models and quantitative analysis.

Part two: “
A Crack in the System”:
For months, several executives at AIG Financial Products had pulled apart the data, looking for flaws in the logic. In phone calls and e-mails, at meetings and on their trading floor, they kept asking themselves in early 1998: Could this be right? What are we missing?

Their debate centered on a consultant's computer model and a new kind of contract known as a credit-default swap. For a fee, the firm essentially would insure a company's corporate debt in case of default. The model showed that these swaps could be a moneymaker for the decade-old firm and its parent, insurance giant AIG, with a 99.85 percent chance of never having to pay out.

The computer model was based on years of historical data about the ups and downs of corporate debt, essentially the bonds that corporations sell to finance their operations. As AIG's top executives and Tom Savage, the 48-year-old Financial Products president, understood the model's projections, the U.S. economy would have to disintegrate into a full-blown depression to trigger the succession of events
that would require Financial Products to cover defaults.

If that happened, the holders of swaps would almost certainly be wiped out, so how could they even collect? Financial Products would receive millions of dollars in fees for taking on infinitesimal risk. …

Credit-default swaps exemplify the contradictions of modern finance. At a basic level, they serve as insurance, but they aren't regulated as such. They have allowed companies to free up untold amounts of capital that otherwise would be tied up as collateral for loans. They were sold both to reduce risk and, in some cases, to give clients room to take on more risk -- a key component to making money on Wall Street.

But in the end, neither the buyers nor sellers truly understood the enormous risks they were creating. Anyone could sell such a swap, and anyone could buy one, even if he had no stake in the transaction. Some buyers used them to bet against failing
companies, prompting a debate among state regulators about whether this type of
swap was a form of gambling.

Part three: “
Downgrades and Downfall”:
The contracts were flying out of AIG Financial Products. Hardly anyone outside Wall Street had ever heard of credit-default swaps, but by early 2005, investment banks were snapping them up to insure all kinds of deals in case of default, fueling one of the great financial booms in U.S. history. …

Once a small part of the firm's business, the increasingly popular contracts had helped boost the company's profits to record levels. The company's computer models continued to show only a minute chance that the firm would ever pay out a dime on the contracts …

The swaps business had bound Financial Products to hundreds of counterparties in New York and Europe. Wall Street firms such as Goldman Sachs and Merrill Lynch favored the credit-default swaps as an extra layer of protection for mortgage-backed securities, one of the many investment by-products helping to fuel the overheated housing boom. European banks liked them because they could treat the swaps as a form of collateral, which freed up cash that the banks would ordinarily have to set aside as protection against losses.

The interlocking, complex nature of these contracts would speed their downfall. When the housing market began to unravel in 2007, it set off a chain of events that would prove disastrous: downgrades in the ratings of securities that Financial Products had insured; demands by Financial Products' counterparties for billions of dollars in collateral; AIG's desperate search for cash to meet the collateral calls; a panicky weekend of negotiations in New York and Washington; and, finally, Treasury Secretary Henry M. Paulson's conclusion that AIG could not be allowed to collapse.

The taxpayer rescue of AIG stands at $152 billion, including $60 billion in loans, a
$40 billion investment in AIG preferred stock and a $52 billion purchase of troubled AIG assets that the government hopes to sell off to recoup its investment. …

So there you go. That should be enough reading to fill the rest of your Sunday.

Or you can wait for the book.

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