Versailles On Balls Hill Road, McLean, VA 22102 - $17.5 million
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WHAT WENT WRONG
in
WALL STREET  and the  REAL ESTATE INDUSTRY?
J. I. Nelson, Ph.D.
McLean, VA
20 October 2008

This 2008 article says the debt is enormous and the TARP bailout is justified.
A later 2010 article says it was  willful fraud, the Fed is printing trillions to hide it, and I was naive to fall for TARP.
The 2010 article is, "The Federal Reserve is Printing Money".

"The Fed was really adamantly opposed to any form of regulation whatsoever."
    --Arthur Levitt Jr., Chairman, Securities and Exchange Commission (SEC), 1993-2001
quoted in Washington Post, 15Oct08, pg A9
 ~=~
"... the burst of the biggest credit bubble in history ... "
The Washington Post, 24Jan09, pg A1

The white elites in banking destroyed their own industry.  New people must step forward to fix it.  This means you.  Writing this helped me sort out the pieces.   You can do it  too.    Take it apart, examine the pieces, don't let them do it again.  

UNWILLINGNESS TO LEND

The financial collapse arises from the unwillingness of anyone with some capital to lend it to anyone else.  This brings investment and economic growth -- as well as short-term business operations -- to a halt.  It is noteworthy that banks and other financial institutions have money, but are afraid to lend it because the financial strength of partners can not be ascertained from balance sheet statements.  The damage is sufficiently broad geographically, widespread across elements of the finance industry, and deep psychologically to guarantee a world-wide recession lasting at least a year.  IMHO, the response of the world's leaders and ruling elites has thus far (20Oct08) been sufficiently piecemeal, inconsistent and even wrong to guarantee great delays in recovery.

THE MORTGAGE CAROUSEL

In broad terms, the last American Chairman of the Federal Reserve, Alan Greenspan, permitted lax enough monetary policies to support rather than contain two bubbles, one in Internet and telecommunications (fiber) investment which lasted until 2001, and another in housing, which lasted until now.  The privatization of social security would have been the third.  

The quasi-governmental status of the Federal National Mortgage Association (ticker FNMA, Fannie Mae) and the Federal Home Loan Mortgage Corporation (FRE, Freddie Mac) enabled them to draw capital into the housing industry more easily.  They were trusted.

Fannie Mae and Freddie Mac drove a mortgage carousel.  Money was lent, came back, and was lent again.  Soon mortgage originators were scraping the bottom of the barrel for new customers.   The proportion of subprime mortgages more than doubled, from less than 10% of all mortgages to more than a fifth.

The carousel turned.  Then Federal Reserve monetary policies piled the carousel ever higher with cash.  The result was that the United States consumed a great proportion of its manufacturing capacity in the unproductive creation of housing.  In the five years between 2002 and 2007, the number of homes that sold for over $1 million more than tripled to 64,300.  Not far from where I live "inside the beltway" in the  metropolitan Washington DC area, you may see houses like this:
Versailles On Balls Hill Road, McLean, VA 22102 - $17.5 million     
click photo to enlarge

In the Washington DC area, small government means big houses.  
Completed in the Spring of 2008, this home on Balls Hill Road, McLean, VA, went on our local housing market at $17.5  million.  




Dominion Reserve Drive, McLean VA 22102 satellite photoSome houses in The Reserve, McLean, marked with red dots.

To look up the map yourself,   just enter

Dominion Reserve Dr
McLean, VA 22102
 
into Google, and ask to see the map you will be offered.  Look around the neighborhood, which is much larger than the few blocks with 50+ homes marked here.  Since the photo was made, houses have been built all along "Founder's Ridge" .  Although there are some mansions at $7 million, the neighborhood has a fairly uniform look and feel.  Most homes are between $3 and $5 million and look like the street below.

















Dominion Resserve Drive, McLean, VA 22102 Satellite view    
click photo to enlarge

Three homes around a  cozy cull-de-sac in The Reserve of McLean, VA 22102




" It's your money, take it back ! "        Fine, but then where does it go?

Here in the National Capital metropolitan area, special factors drive the housing market.  The attack on civic government by the Republican Party ("It's your money, take it back") has hollowed out public service.  Services must still be performed, but now private corporations handle them.  The few civil servants remaining in public service often lack the expertise, let alone the authority, to monitor private contractors feeding on public funds.  

In the suburbs of  the nation's capital, "small government" means big houses.  

In the country as a whole, the monetary policies that supported the dot.com boom and bust also enabled the housing boom and bust.  In housing, those funds could be recycled with ever-faster turns of the money carousel.  Those recycling mechanisms, and the mortgages themselves, need to be appreciated to understand how the enterprise  could spiral into a pile of financial instruments with a multi-trillion dollar face value.  The true value was much less, which doomed the bubble to burst.  But how much less was not knowable, which added the elements of mistrust and fear, and **that** is what froze the banks and sank the stock market. 

ROTTEN FOUNDATION

Let's start with the mortgages.
The financial collapse has at its roots the fraudulent application for mortgages.  Applications falsely stated such things as the applicant's employment status, income, credit rating and credit history.  Mortgage terms were constructed to be both compelling for deal closure  and conducive to failure. 

Mortgage terms conducive to closing the deal include no money down, low interest rates, unwarranted promises about cashing out at any time by easily selling the house if one could no longer carry the obligation.  Selling mortgages with excessively conducive terms is called "predatory lending."  Mortgage terms conducive to failure include lending to someone with little income in the first place to support the payments and  ballooning interest rates rather than fixed ones.  Who was stupid and who should now take responsibility for her actions, the lender or the borrower?

Predatory lending with :"sucker rate" balloon mortgages targeted poorer people as Fannie Mae, Freddie Mac and the rest of the mortgage lending industry went down-market into virgin territory where  people did not already own homes.  But there will be foreclosures among the million-dollar homes that grace my neighborhood and this Web page.  By August 2008,  7,968 homes that had sold for over one million dollars were already in foreclosure nationwide.  We all await the first tear-down that replaces one with something smaller and more useful.

So was it the lenders fault or the borrowers?  Blame doesn't matter if you are looking for social policies that got us here, that must be changed to get us out again.  The mortgages were sold because the sellers were paid to sell them.  Bad policy.  But then free-lancing mortgage brokers sold a mortgage again.  And again.  How was this possible?   Beyond policies to reward an individual's bad behavior loom structural problems in society as a whole:  the money machines.  

SECURITIZE THE MORTGAGE,
HAUL IN MORE MONEY, DO IT AGAIN

Today we securitize bundles of mortgages and to sell them as securities, bonds or other financial instruments (e.g., collateralized debt obligations).  People who sold these financial instruments earned a commission on each sale and were incentivized to invent more ways of reselling mortgages.  They invented and sold new instruments.  They turned to a wider spectrum of investors in many countries and outside the real estate industry.

Retail mortgages have a higher interest rate than large commercial loans to corporations, much higher than government loans (Treasury bonds).  Mortgages repackaged as bonds paid a higher return than other bonds.  Banks investing in them could offer higher savings interest.  Mutual fund managers could expect higher returns.  The returns offered to pension fund and college trust fund managers (professional investors) were higher than other investments.  When new customers bought the new forms of debt (new ways to repackage bundles of mortgages), their money financed the creation and sale of yet another round of mortgages.   The mortgage carousel turned.  New home buyers had to be found.  

All these players bought the rights to participate in the money stream from homeowners paying their monthly mortgage.  The players' (investors') money returned to Main Street in Everytown, where  freelance brokers beat the pavement looking for people who still did not own a mortgaged home.  Good companies involved in the housing mortgage industries had to lose their market, had to lose business, unless they joined their "live-for-the-day" competitors in a race to the bottom.  People at the bottom are sub-prime credit risks and their homes are purchased with "sub-prime mortgages".  Often they were even worse than this: they did not qualify for **any** mortgage, and their application was falsified. 

The carousel turned.  Each person on every horse collected his commission.

QUASI-GOVERNMENTAL AGENCIES OF PUBLIC POLICY

Public policy to create securitized mortgages and the creation of  semi-public institutions to run the securitization process is rooted in public policy to provide everyone with his own home.  The agencies that ran large securitization operations were Fannie Mae  and Freddie Mac, the  Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FRE,Freddie Mac)  

Fannie Mae and Freddie Mac (the latter with more than four large headquarters buildings in McLean, VA)  sped the carousel by running enormous server farms and databases to keep track of all the mortgages. They increased the weight of money on the carousel by attracting investors in remote industries and far away countries with the appearance of government backing. 

The databases on every mortgage and the government-sponsored status provided a feeling of safety to the buyers of bundles of mortgages.  It seemed possible to check the safety of the home payment money stream by drilling down to the details of any particular mortgage, or to scan millions of them to pull out normative averages.   It seemed the government might treat Fannie and Freddie as "too big to fail".  The investments seemed safe and they were bought, repackaged, and bought again. 
 
Two headquarters buildings for Fannie Mac on Jones Branch Road in McLean, VA 22102
 
Two of Freddie Mac's five HQ buildings in McLean.  Large server farms and storage arrays hold data on all of the mortgages backed by Freddie Mac ("conforming loans"), and most of the bundled mortgages bought and traded by them from other players in the "secondary" (securitized) mortgage industry. 


NEW AND UNREGULATED DEBT INSTRUMENTS

Mortgage brokers and small banks have to bundle and sell their mortgages in order to receive the funds that turn the housing carousel one more time.  The bundles were often first "securitized' as bonds.  Larger players could buy the bonds and earn a commission repackaging and reselling them as another instrument, perhaps a collateralized debt obligation (CDO).  CDOs were divided into secure, middling and risky but high-interest "tranches" that sounded orderly and secure.  Those more sophisticated financial instruments were resold to larger or more sophisticated customers.  

The financial industry was incentivized to invent ever more debt instruments which were more remote -- more highly "derived" -- from the underlying asset; namely, your neighbor paying her monthly mortgage.  The invented financial instruments grew ever more complex. 

Because collateralized debt obligations are complex, many people are needed to create and sell them.  Each earns a fee:  the Underwriter, the Asset Manager, Accountants, Attorneys, and the Trustee and Collateral Administrator (e.g., Freddie Mac, maintaining  the mortgage data bases).   

The creativity of financial institutions -- creating more "product" -- was rewarded by added fees and evaded regulation.  This is not "greed and corruption" in Wall Street.  This is creativity in making use of the framework -- the corporate playing field -- that was handed to the industry.   

"[Nouriel] Roubini argued that ... skewed incentives ... had almost guaranteed the eventual crackup.  Mortgage companies had offered dubious subprime mortgages, for a fee; investment banks had turned them into exotic securities, for a fee; rating agencies had given them artificially high marks, for a fee.  The system 'worked,' you might say."
 --David Ignatius, Washington Post 1Feb09 pg B7, after attending and chairing discussions at Davos.
The World Economic Forum at Davos, Switzerland is a CEO club attended this year also by the Chinese Premier (Win Jiabao), the Russian kingpin and Prime Minister (Vladimir Putin), and other, mostly European, political leaders.  
SWAPS
"The most visible of the gaps in existing regulations is the $55 trillion notional [hidden] market in credit default swaps. ... Just as important as improved regulation in these areas is transparency for investors.  Transparent markets require less outside intervention because investors can make rational decisions."
-- Christopher Cox, current Chairman, Securities and Exchange Commission, writing in the Washington Post, 4Nov08 pg A17.  Cox was nominated by G.W. Bush and confirmed in June, 2005.  

I will mention only one other higher form of financial instrument, the credit swap.  Credit swaps could be written against a variety of different events, such as the default of a large financial borrower. That would be a credit **default** swap.   The word is probably unfamiliar to you, and that's the whole point, as this quote explains:  

 "Former staff member of the Commodity Futures Trading Commission, Michael Greenberger describes a credit swap in brief: 'A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails. It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated.'"   http://en.wikipedia.org/wiki/Credit_default_swap

Credit default swaps were created (invented) ca. 1998, only about 10 years ago, but today provide insurance for at least $35 trillion of loan agreements, based on contracts held on behalf of their may clients by the Depository Trust and Clearing Corporation.  If we imagine hypothetically an insurance commission of 1/10th of one percent on a premium value of $35 trillion, the invention of credit default swaps means the invention of a new revenue stream worth $35 billion dollars.  It was a great party while it lasted.

The national government loaned the insurance company American International Group (AIG) $85 billion on 16 September 2008, in part to cover AIG's credit default swap insurance policies on companies that were indeed defaulting on their loans.  The Federal Reserve made another $37.8B available to AIG on 9 October.  Will this be enough?  On 30 November, $20B more was made available to AIG from the "commercial paper bailout fund."  Will **this**be enough?

The Depository Trust and Clearing Corporation computer servers hold complete contract information for the credit default swaps of its clients.  But those $35 trillion in obligations are not the limits of the complete credit default swap industry, which a derivative industry group pegs at $55 trillion.  A 10 or 20 trillion dollar uncertainty in how much debt is insured and how much a full and effective bailout would cost cannot be resolved, because financial firms are not required to list "swaps" on their balance sheets.  Besides rendering the industry partially invisible, lack of visibility on balance sheets causes trading partners to grow too suspicious and fearful of one another to do business together (to lend money).

Healthy free markets have good visibility but  this one does not.  Indeed, there is no open market in derivatives of any kind -- they are traded on no public exchange.  The global market for derivatives of all kinds  was over $530 trillion as of mid-2008.  Compare the value of all stocks listed on the New York  Stock Exchange (NYSE), which was $30  trillion before the current collapse. .  A "dark market"  17 times the size of the NYSE is in the hands of professionals whom we should trust, says Allen Greenspan: 

"Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.  And participants in financial futures markets are predominantly professionals that simply do not require the customer protections that may be needed by the general public. ...  Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living. "  Allen Greenspan (Chairman, Federal Reserve, 1987-2006)    (Congressional testimony, 1998).

EBAY logoMarkets are a good thing.  If you want to come to the eBay market, you had better have a good feedback rating. If you screw up once in a while, be responsible and take care of your customer -- protect your rating or lose your ability to list.  eBay also makes some effort to set aside some of their earnings in a reserve to complete deals that get broken -- buyers who never pay, sellers who don't deliver.  Getting all transactions completed (cleared out of the marketplace) makes for a more orderly auction market.  eBay says, If you want to trade, we have the most active market.  Come to us, but play by a few rules that we all follow here.

We all understand eBay.  We can all demand the same for derivatives. We can all say, " If you want to list, play by a few simple rules.  We'll give you a market that  is open like eBay, that has a clearing house to keep the market orderly by clearing out deals that get broken.  But it will be pay to play.  You derivative holders  have to maintain certain publicly-disclosed (transparent) cash levels so that you can deliver on your own promises most of the time.  The days of hundred billion dollar bailouts are over.  It's not 2008 anymore."

Just because they are complex does not mean you cannot raise your voice against credit default swaps.  If you majored in English and don't know economics, you can still say, "Let's call these CDS's 'default insurance'.  That's what they are."  We can all still say, "Put more information on your balance sheets.  List the swaps." 

Transparency attracts investment, and we need the money.

THE HOUSE OF CARDS

The house of cards is now complete. 

1. Mortgages have been resold as bundles, re-created and resold so many times that houses that should not have been built have now been sold to people who should not have bought them.  The mortgage carousel kept turning. 

2. Many sources of money (pension funds, college endowments) have been tapped in many countries around the world to give Americans a standard of living they could only attain on borrowed wealth. 

3. Instruments of little transparency and no regulation have been created by the financial services industry.  The new instruments earn fees for many but can be understood by few.  This lays a foundation for mistrust among thousands of financial institutions, including the largest ones in the country, who cannot judge the strength of any potential lending partner's balance sheet.

4. The value of the collateral of collateralized debt obligations worth over $35 trillion dollars can be surveyed by computer, but many data on mortgage holders prove to be fraudulent.  "Garbage in, garbage out," as computer people say. 

The collapse of the house of cards cannot be fixed by spending $700 billion dollars on a bail-out (plus $250 billion in pork handed out to buy votes to pass the bailout legislation) because structural problems not corrected by money exist and undermine trust.

THE PROBLEM WILL LAST

The problem will last because it has psychological and structural dimensions not addressed by handing out money.

The money being handed out to lenders is saving institutions that should fail as management and business entities.  There is  toxic debt that cannot be valued because of complexity, and that complexity is seen to hide underlying fraud when it is peeled away.  Money handed out to save banks that should fail does not remove toxic debt that poisons the system.

Money handed out to creditors (the financial institutions, the mortgage recycling carousel operators, the inventors of lucrative but hidden financial instruments) does not help borrowers.  Borrowers are the millions of homeowners who cannot go shopping to rescue the economy after being dumped on the sidewalk with their furniture.  This, too, will have its psychological dimensions of fear and mistrust that can prolong our mutually shared downward journey.  Failure to aid debtors will reap fear and economic paralysis as surely as fear and mistrust among the banker classes has stopped their lending.

No financial solutions -- those proposed for lenders, those yet to be proposed for borrowers -- can solve the structural problems in the housing and financial industries which incentivized bad behavior, encouraged financial arrangements burdened with opacity and doubt instead of transparency and trust, and which failed to recognize eternals of human behavior, such as deception in the pursuit of self-interest.  Regulations that were dismantled or sidestepped need to be replaced by ones that are not. 

There are many policy issues to focus on and to formulate beyond merely injecting $700 billion into the banking system.  In the waning days of a right-leaning Administration, seven hundred billion dollars is being transferred mostly from working-class citizens into the hands of the ruling elite.  Yet the nation's top legislative body did not address any of the major policy issues now hanging fire. Instead,  it spent a week bribing itself with $250 billion to get the votes to hand itself $700 billion to help a minority of the country's citizens.  This does not bode well for the depth of the economic depression the world now faces at the hands of failed American leadership.

--jerry
DEDICATION

I dedicate this essay  to Columbia Partners Investment Management and to all the creative and quantitative professionals I met there.  People who manage the investment of pension funds and wealthy clients' assets depend on the honesty and transparency of the market  just as anyone else does.  Investment and portfolio management is the bright, silver lining in a now tarnished industry.
 
J. I.Nelson, Ph.D.
McLean, VA 22101

Foreclosed multi-million dollar home in The Reserve, McLean, VA

top of this      2 yrs later -  the 2010 article         politics area generally             home page of everything


20October2008    Rev4NovCox+AIG$  Rev24Jan09WPostWorstBubbleQuote
Rev 27Jan09DedicationToBlacks  1Feb09AddIgnatiusQuote
Rev 1May10 Shorten dedication, add foreclosure photo
Rev 23Oct10 Better estimate of total mortgage value: 11 trillion dollars