The Great Deformation (81 page)

Instead, beginning in June 2004 it began raising the absurdly low 1 percent Federal funds rate in baby steps—25 basis points at a time, month after month, for the next two years. Dithering with the Wall Street gambling halls in this manner, however, merely enabled them to push bubble finance into new crevices of the national economy.

As detailed in
chapter 19
, the most consequential of these hot spots was the final flourishing of the subprime and other high-risk mortgages. Even a cursory analysis demonstrates the Fed's direct culpability for the fiasco which eventually materialized and that its plodding pace of short-term rate increases resulted in the worst of both worlds.

On the one hand, firming monetary conditions did steadily curtail the growth of adjustable rate mortgages, or ARMS, which had been the driving force of the refinancing boom. Thus, when the one-year ARM rate rose from 3.5 percent in April 2004 to 5.5 percent two years later, the issuance of ARMs to creditworthy (prime) households fell sharply, falling from a peak rate of $2.5 trillion to only $1 trillion by 2006.

At the same time, the Fed's continuous assurance that rates would rise at only a snail's pace gave the Wall Street mortgage warehousing and securitization machine sufficient time and cheap funding to dramatically crank up subprime lending volumes. In this manner, the hole left by prime-quality ARMS and other conforming mortgages (which could be sold to Fannie Mae) was backfilled with a huge rise in high-risk mortgage issuance funded on Wall Street.

The Fed's temporizing was exactly the wrong prescription. What was needed now was a Volcker-style policy pivot that would have shut down the nation's vastly oversized mortgage lending machinery before it could wreak any more damage. Instead, the Fed effectively turned the dogs of Wall Street loose on the lower middle class.

The reason for this destructive venture was obvious: by that point the ranks of willing, credit-worthy borrowers were getting increasingly thin. A dramatic sign of that was the soaring inventory of existing homes for sale, which rose from a normal level of 2 million units in January 2005 to 4 million just twenty-four months later. The ranks of available purchase mortgage buyers had materially dwindled, perhaps because after housing prices flattened out the prospects for instant gains were no longer so compelling to flippers.

At the end of the day, however, it was the final surge of the home ownership rate which provided the telltale sign that the mortgage lending machine was morphing into a financial predator. By June 2003, the home ownership rate had already reached an all-time high at 68.2 percent. As previously shown, it had been climbing steadily for nearly a decade from an apparent equilibrium level of 64–65 percent that had prevailed from 1980 through 1994.

Had the Fed not chosen to designate itself as Wall Street's juicing vendor of first resort, it surely would have recognized that the bottom distribution of American households was becoming decidedly less capable of home ownership. Household income in the lower brackets was then falling rapidly in real terms, owing to the withering pressure that had been visited upon American wage scales by the export factories of East Asia. Yet the home ownership rate was pushed still higher in the final flurry of “no doc” and “neg am” subprime lending, and hovered above 69 percent during most of 2004 through early 2007.

In the egregiously cynical nomenclature of the subprime world, the first of these newly invented mortgage finance terms meant a borrower could lie about his income, and the second meant that it didn't matter anyway. If a household came up short on cash, it could elect to add some, or possibly even all, of its monthly payment to the outstanding balance of its mortgage.

Not surprisingly, the boiler-room mortgage brokers had no trouble dispensing massive dollops of cash from Wall Street's warehouse lines to finance borrowers who didn't have the ability or need to pay their monthly mortgage. So doing, they touched off an economic flash flood. The resulting sudden surge and then abrupt end of subprime mortgage originations is among the greatest financial deformations ever fostered by the prosperity managers in the Eccles Building.

HOW WALL STREET BROUGHT SUBPRIME OUT OF THE PAWNSHOPS

While the subprime business fully emerged from its historic pawnshop-style venue during the 1990s, it had remained a modest segment of the mortgage market, accounting for only 9 percent of total home mortgage originations during the eight years ending in 2002. By 2004, however, subprime originations had spiked from about $125 billion per year to $530 billion and thereafter climbed above $600 billion each year during 2005–2006. At that point, subprime loans accounted for nearly 25 percent of total mortgage lending.

Moreover, these totals do not include the only slightly less dodgy “Alt-A” segment which sported somewhat higher credit scores, but consisted
overwhelmingly of “no doc” and “neg am” mortgages. These “liar loans” grew like Topsy, rising from $60 billion in 2001 to $400 billion by 2006.

But that's not all. During this same interval, the “second lien” mortgage business of the big money center banks like JPMorgan and Bank of America also went into high gear. Second mortgages are inherently lower quality because they get the scraps in a foreclosure, and only after the primary mortgage is paid off in full. Still, in the sizzling mortgage markets of 2001–2006, originations of second mortgages and home equity lines of credit grew from $130 billion annually to $430 billion per year.

Needless to say, this explosion of second liens put millions more Main Street households in harm's way because the financings frequently brought total loan-to-value ratios (including the first mortgage) close to 100 percent. These borrowers simply had no margin for error in terms of either an unexpected housing price drop or the loss of employment and income.

On an overall basis, therefore, the three classes of higher-risk credit accounted for almost 50 percent of new mortgages during 2006 and totaled nearly $1.5 trillion that year alone. The degree to which the mortgage market came unhinged is hard to overstate: more “high risk” mortgage money was dispensed in 2006 than the annual total for all mortgage lending during any year prior to 2001.

The Fed's baby-step (25 basis points) interest rate increases during 2004–2006 therefore did not shut down the housing boom; it just drove it into the highest risk neighborhoods in America and piled debt on households which were least capable of coping with it. The prosperity managers at the Fed should have been scared out of their wits by this development but the record shows that, actually, they didn't give a wit.

Throughout the entire period of 2004–2006, the meeting minutes celebrate the strength of housing and the manner in which financial “innovation” such as mortgage securitization was spreading the blessings of home finance. Not a single meeting focused on the drastic and unprecedented deterioration of mortgage credit quality that was under way.

Nor was there any mystery about the data. A private industry-based publication called
Inside Mortgage Finance
faithfully reported, week in and week out, all of these trends and the drastic shift after 2003 to high-risk mortgages. So the nation's monetary politburo should have known during the final housing surge of 2004–2006 that an economic time bomb was being planted at the very center of the Main Street economy: cumulative originations of subprime, Alt-A, and second-lien mortgages totaled a staggering $4 trillion over that final period.

No thanks to the Fed, the high risk mortgage party did eventually have its Wile E. Coyote moment. In response to rapidly surging default rates,
new originations of these loans dropped right off the cliff, plunging to a negligible $100 billion in 2008.

As in so many other instances, however, the extreme violence of the subprime/Alt-A/second-lien cycle was not an honest manifestation of business activity on the free market. The eight year round trip from annual issuance of $150 billion to $1.5 trillion and then back to $100 billion was still another deformation fostered by the age of bubble finance.

JOHN MAYNARD GREENSPAN AND THE CULT OF THE “PRINT”

It goes without saying that the explosion and then crash of the high risk mortgage market amounts to an everlasting black mark against the Fed. Its culpability lies not merely in the grotesque amount of predatory lending that unfolded, but even more acutely in the fact that it turned a blind eye in pursuit of its prosperity management model. The only thing which mattered in the Eccles Building was the quarterly and annual pace of mortgage originations. In purely Keynesian fashion it embraced the mortgage explosion because the proceeds from these loans goosed consumer and investment spending in a manner that was indistinguishable from spending out of current income.

In turn, higher spending meant more GDP, rising asset prices, and a higher stock market. At bottom, the prosperity model of the Greenspan Fed was a revival in modern guise of the old illusion that a nation can borrow its way to prosperity.

There was a large irony in this. Greenspan 1.0 had been anti-Keynesian to the core and had rightly debunked the asset bubble of the late 1920s as an artificial by-product of too much speculative credit. By contrast, Greenspan 2.0 embraced what was surely a proto-Keynesian viewpoint by turning his old equation upside down.

In the new version, rising asset prices came first. Whether this asset inflation was caused by sunspots or the machinations of the Fed itself, the maestro did not say. But, mirabile dictu, the mountains of debt piling up on the nation's balance sheet were not worrisome because the value of housing assets had risen even more. The debt-to-asset ratio had actually fallen!

So the $4 trillion explosion of high-risk mortgage debt during 2004–2006 went unremarked by the monetary central planners because this mighty flow into current spending boosted the “print.” The latter consisted of a dozen or so regular economic “stats”—including nonfarm payrolls, retail sales, disposable personal income, housing starts, existing home sales, capital spending, corporate profits, and GDP—that purportedly summarized the macroeconomic picture. These indicators provided Wall Street
speculators with leads on the likely direction of the Fed's prosperity management policy and, therefore, the most attractive trades to front-run.

By the time the mortgage market deformation reached its apex in 2004–2006, the Fed was totally in the tank for Wall Street. It did not even dare talk publicly about the unhealthy trends and deteriorating structural conditions which threatened the nation's surface prosperity, for fear of spooking the speculators who were keeping stock prices and risk asset values rising. The mortgage bubble was contributing to an improved current period “print,” and that's all that counted. The profound deterioration of credit and the economic deformations which were brewing down below were simply ignored.

THE LEGEND OF FINANCIAL “INNOVATION”:

WHY MORTGAGE SECURITIZATION REALLY HAPPENED

In truth, the vast outpouring of subprime and other high-risk mortgages were not underwritten by the descendants of George Bailey's savings and loan. Community-based banks and thrifts universally eschewed subprime loans if they had to fund them out of their own deposits and assume the permanent balance sheet risk.

The experienced underwriters working in their mortgage departments could readily see that there was not enough margin, even at the elevated subprime interest rates, to cover probable default losses. Accordingly, fully 82 percent of the subprime loans written during 2004–2006 were bundled, securitized, and laid off on the capital markets; that is, not retained on the balance sheets of the original lenders.

It is now evident, of course, that separation in this manner of mortgage underwriting from long-term balance sheet retention had been a fatal mistake. Yet, at the time, the official propaganda from both the Fed and Wall Street described this division of economic functions as one of the great “innovations” of modern finance because it permitted risk to be sliced, diced, and reallocated to allegedly better suited investors.

Even when dressed up in all its academic finery, however, this shiny new theory of “risk shifting” actually boiled down to a clever rationalization for money printing. There really wasn't any economic merit to it. The major attribute of structured mortgage finance was that it generated endless opportunities for rent seekers to extract fees, scalp trading spreads, and misprice the original risk as it wended its way through the chain of securitization.

The truth of the matter is that “risk” in a mortgage is created on the spot where it is approved and funded. From that point forward, every time a mortgage is handed off—from the loan production office, to the mortgage
wholesaler, to the mortgage bond underwriter, to the rating agency, to the CDO packager, to the Wall Street sales and trading desk, to the Norwegian fishing village's investment fund—the original risk gets pooled, averaged, structured, and obfuscated.

Yet the original underwriting risk does not get reduced or mitigated. Therefore, the stated rationale for all of these dead-weight transaction and information costs along the way, to say nothing of the exposure to fraud, was “portfolio diversification” and investor risk selection.

As it happened, real-world outcomes have made a laughingstock of these diversification theories. The alleged gains to investors from a wider mix of geographies, mortgage structures, and borrower profiles were swamped by the disinformation that accumulated along the chain of securitization. Likewise, the tranching of securities issued by mortgage-backed conduits misled investors seeking to calibrate their exposure to losses because the risks embedded in the underlying pools were drastically underestimated.