The Great Deformation (82 page)

Accordingly, losses to date on the $3 trillion of non-GSE mortgages that have been securitized total an estimated $1 trillion. This means that had these mortgage derivatives been accurately priced (i.e., to cover losses) in the first place, the true economic cost to investors of achieving portfolio diversification—through this crude form of model-driven, multibillion mortgage pools—would have been prohibitive.

Stated differently, the entire mortgage-backed security (MBS) and collateralized debt obligation (CDO) industry would never have gotten off the ground on the free market. Since giant mortgage pools do not make underwriting risk go away, the only real justification for securitization was lower processing and servicing cost. Yet there was never any empirical evidence of meaningful economies of scale in pooling mortgages after they are written. Indeed, a few years later the evidence against it is unequivocal: the world's lowest cost mortgage processing programs can now be accessed anywhere on the planet from an iPad.

The preponderant form of mortgage securitization was the $6 trillion of government-guaranteed securities written by Fannie Mae and Freddie Mac. But as shown in
chapter 19
these are just gussied up Treasury bonds that shouldn't even exist. Likewise, the $2.5 trillion of “private label” mortgage-backed securities packaged by Wall Street from subprime and Alt-A loans thrived for a brief interval owing solely to the bubble finance policies of the Greenspan Fed.

As explained in
chapter 1
, these money-printing policies showered Wall Street with artificially cheap wholesale funding which enabled it to float massive, high-risk mortgage pools. These mortgages were first gathered by
predatory brokers who scoured Main Street neighborhoods looking for junk mortgage borrowers and then funded the resulting loans on Wall Street–provided “warehouse” lines. When these lines were periodically flushed onto Wall Street balance sheets, the loan paper was held only long enough to scalp a generous slice of profits as it passed through the securitization machinery and out into the world of unsuspecting and, often, clueless institutional money managers.

At the back end, Wall Street's sales and trading operations foraged the planet for institutional investors who were foolhardy enough to “lift” its offers of essentially incomprehensible math-model securities. But in unloading this toxic waste, Wall Street was not functioning as an agent of the free market bringing consenting adults together for a trade; there simply wasn't any free market in subprime mortgages.

NO SUBPRIME ON THE FREE MARKET—JUST FED-ENABLED RE-FI

As indicated, sub-prime lending emerged from the shadowy world of pawnshops, but there was no resemblance in business models at all. The pioneers of this new model, such as the notorious Guardian Savings and Loan and Long Beach Savings, operated on a fundamentally different principle—that is, bad loans were refinanced, not re-possessed.

Whereas old fashioned hard-money lenders like Household Finance and Beneficial had made financial ends actually meet by seizing collateral upon borrower default, the new subprime brokers only made ends appear to meet by refinancing loans as soon as they got in trouble. This maneuver made for better default statistics and drastically reduced collection costs but, alas, it was fatally dependent upon a continuously rising housing market.

The broker-based subprime model was thus an offspring of the Fed's bull market in housing and, in fact, was guaranteed to fail the minute the housing price spiral stopped. The founder of Guardian Savings, for example, famously insisted that borrower ability to make the monthly payment had nothing to do with his new-style subprime lending. “If they have a house, if the owner has a pulse,” quipped Russell Jedinak, “we'll give them a loan.”

Sometime later, one of Jedinak's disillusioned collaborators completed the picture with respect to Guardian's business model: “They were banking on a model of an ever rising housing market.”

Needless to say, rising housing prices and serial refinancings did wonders for reported default rates. Before failing loans could hit the default statistics, subprime lenders kicked the can down the road, converting imminent or actual defaults into new originations. Bearish evidence of stress
and underwriting failure was thereby transformed into bullish signs of growth in lending volumes.

Not surprisingly, nearly 85 percent of these early vintage subprime mortgages were refinancings. Often these were of the “cash-out” variety, meaning that borrowers were given enough extra cash to meet the monthly payments until the next refinancing. In this manner, such borrowers remained “current.”

This kind of “churn” was an old trick of scam artists in traditional securities markets. But prior to the 1990s there had never been a strong, chronic inflation of residential housing prices in the context of deregulated financial institutions. Accordingly, even one of the astute founders of the government mortgage-backed securities business, Larry Fink, could not imagine a market for privately securitized subprime loans.

Asked by a congressional committee in the late 1980s whether Wall Street might try to securitize risky mortgages, Fink dispatched the notion cleanly: “I can't even fathom what kind of mortgage that is … but if there is such an animal, the marketplace … may just price that security out [of existence].”

In short, the subprime mortgage industry was not a natural product of the free market. Instead, it was a deformed by-product of the financial asset inflation the Fed persistently fostered after its October 1987 Black Monday panic. Larry Fink failed to imagine that highly risky mortgages could be economically securitized because he had not yet realized that cheap mortgage debt and rising housing prices would converge in a hidden default cycle of rinse and repeat.

CHURN AND BURN: HOW THE HOUSING PRICE SPIRAL FOSTERED THE MORTGAGE BROKER PLAGUE

The financial innovation labs of Wall Street did, in fact, invent the estimable mechanisms of credit enhancement such as overcollateralization and senior-subordinated tranching of subprime mortgage pools. But all the razzmatazz of structured finance did not make subprime lending safer or more financially viable.

Securitization just shuffled around among the various investor classes the drastically underestimated default loss projections cranked out by subprime underwriters. Not only did these projections suffer from the inherent refinancing bias of a bull market in housing, but this contamination of the performance data actually became more severe as the housing price spiral accelerated.

This pernicious feedback loop was crucial to the final explosion of the subprime mortgage market in 2004–2006. It was not coincidental that the
single most nefarious operator among the rogue's gallery of subprime entrepreneurs, Roland Arnall of Long Beach Savings and Ameriquest fame, ceremoniously ditched his thrift charter in 1994. This was a smoking gun. Just as the subprime party was getting started, its most important figure elected to go the pure mortgage banker and broker route—funding his originations with warehouse credit lines and wholesaling the resulting mortgages to the incipient Wall Street securitization machine.

Here, then, was one of the great financial deformations which emerged from the age of bubble finance. A multi-trillion business in dodgy housing loans was eventually built by mortgage brokers who could not actually raise capital or funding on the free market and, indeed, not even in the state-supported market for insured deposits. At the end of the day, it was only when the Fed flooded Wall Street with liquidity after December 2000 that Larry Fink's “impossible” market achieved liftoff.

Indeed, absent the rise of the mortgage banker and broker industry and the GSE and Wall Street financing channels on which they were wholly dependent, the next decade's disastrous breakdown of mortgage credit quality might never have happened. The data show that the stiff-necked loan officers who populated the Main Street banks and thrifts which survived the savings and loan meltdown gave subprime mortgages a wide birth, putting up less than 1 percent of their balance sheets for these risky assets.

The nation's epic housing disaster was thus not inevitable, but was spawned by Washington policy makers who adopted serial measures that put housing and mortgage finance squarely in harm's way. So doing, they brought the gambling mania to America's neighborhoods, and, in the end, to the most economically vulnerable among them.

CHAPTER 21

 

T
HE MENACE POSED BY THE TOTTERING MEGA-BANKS, THE MASSIVE
housing bubble, and the household consumption binge, among others, was definitely not noticed in the Eccles Building. Instead, the Fed went all-in on the Great Moderation, and after January 2006 was led by the theory's own self-deluded proponent. Wall Street had christened this alleged combination of low inflation and moderate growth as the “Goldilocks economy” and, believing Bernanke could perpetuate it indefinitely, drove the stock averages back to their dot-com bubble highs and beyond.

There was no Goldilocks economy, however, and the stock indices were being artificially levitated by a spree of destructive financial engineering fostered by the Fed. The real numbers showed that the American economy was failing: inflation was being temporarily repressed by the export factories of China, not by the deft maneuvers of the Fed. And real GDP was actually just limping along at its worst rate since the 1930s, notwithstanding the wholly unsustainable growth of household debt.

So the nation's monetary politburo should have been focused on quashing the debt-fueled outbreak of corporate financial engineering, that is, leveraged buyouts, M&A takeovers, and stock buybacks. That these true dangers were completely ignored was in large measure attributable to the fact that the Fed was now in the hands of a timorous academic who didn't have a trace of Volcker in him—who wouldn't even dream of facing down the Wall Street gamblers, looters, and empire builders who were taking the financial system over the edge.

BERNANKE'S DEFLATION HOBGOBLIN AND MORGAN STANLEY BAILOUT II

The reason that Bernanke could not do his job and bring Wall Street's speculative furies to heel was not merely personal weakness. He was obsessed
by theoretical hobgoblins of deflation and depression. As detailed in
chapter 8
and explicated further in
chapter 29
, these were not remotely relevant to the actual circumstances of the American economy. So when the destructive Greenspan bubble began to deflate, the Fed did not permit the markets to liquidate what remained of the Wall Street train wreck it had fostered.

Instead it retreated into headlong panic, pulling out every imaginable stop to reflate these dying financial behemoths. The Bernanke worldview thus engendered a level of desperation in the Eccles Building that knew no bounds. Falsely believing that the US economy was heading for a Great Depression 2.0, the Fed not only expanded its balance sheet by $1.3 trillion in thirteen weeks—that is, by $600 million per hour—but did so in a manner that was utterly indiscriminate and without principle or plan.

As detailed in
part 1
, the Fed's alphabet soup of cash-pumping programs effectively nationalized the entire $2 trillion commercial paper market, guaranteed the checking accounts of everyone including Exxon, Microsoft, and Warren Buffet, and wantonly handed AAA-rated General Electric $30 billion of loan guarantees. It even artificially propped up the ABCP market so that the likes of Citigroup could continuing booking profits the very nanosecond customers swiped their credit cards.

These cash-pumping actions were so reckless that even the outrageous anecdotes to which they gave rise can scarcely capture the lunacy rampant in the Eccles Building. In one ludicrous case, therefore, the nation's central bank actually guaranteed upward of $200 million that had been borrowed by two New York housewives to start a new business. Amazingly, the purpose was to enable this intrepid duo to purchase large volumes of securitized auto loans about which they knew nothing.

Even in November 2008, the American economy did not need two amateurs to make car loans. The Main Street banks were flush with cash and willing to make such loans to any creditworthy buyer. Likewise, these two housewives most especially did not need a bailout from the Fed: their husbands were the top executives of Morgan Stanley, a firm that by then had already received its own bailout.

Foolish episodes like this one underscore the pathetic consequence of Bernanke's doctrinal error. He was so desperate to prop up Wall Street that he approved a $200 million car loan to Christy Mack, the wife of John Mack of Morgan Stanley, and her social pal, Susan Karches.

In truth, the real problem facing the Fed was not another externally based industrial collapse like the Great Depression, but a long twilight of internal debt deflation. The tip-off was evident in two key economic variables with sharply divergent peak-to-peak growth rates during the alleged economic boom of this century's first decade.

The first of these was nominal GDP, which grew at a modest annual rate of 5.1 percent over the seven-year business cycle ending in late 2007. The second measure was total credit market debt outstanding, which bounded upward at nearly double that rate, rising by 9.2 percent annually. It wasn't a sensible or sustainable equation, a truth that is self-evident in the whole numbers.

Total debt outstanding surged by $23 trillion, rising from $27 to $50 trillion between 2000 and 2007. The nation's nominal GDP, however, grew by only $4 trillion (from $10 to $14 trillion). During the second Greenspan bubble it thus took nearly $6 of new borrowings to generate another $1 of national income.