BOOK REVIEW

Dear Mr. Buffett
by
Janet Tavakoli

Page Contents

Allocation of credit

Stock options

Mortgage backed securities

Collateralized debt obligations

Investment bank regulation

Ratings agencies

Credit crunch

Bond insurers

 Regulatory failures

FUTURECASTS online magazine
www.futurecasts.com
Vol. 11, No. 7, 7/1/09

Homepage

The Credit Crunch

Government allocation of credit:

 

Moral hazard and conflicts of interest!

  Janet Tavakoli is an expert on sophisticated financial instruments and maintains a close correspondence relationship with Warren Buffett. In "Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street," she explains the myriad elements of the Credit Crunch financial crisis up to about October 2008. Moral hazard and conflicts of interest lurk at every level of this convoluted story. See, "Moral Hazard & Conflicts of Interest."
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 Money managers viewed mortgage backed securities as particularly safe because they were secured by solid collateral such as homes and commercial property. Americans have for a long time had a reputation for paying their mortgages.
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  However, this confidence didn't account for the unintended consequences of government interference with credit markets. Since the 1980s, government has been allocating increasing flows of credit into the housing market and reducing lending standards. Tavakoli sets forth the vast alphabet soup institutional framework behind this policy.

  "A network of Federal Home Loan Banks makes low-cost loans to banks and financial institutions so that they can lend money to mortgage borrowers. The Federal Housing Administration, FHA, part of the United States Department of Housing and Urban Development, or HUD, insures mortgage loans made by FHA approved lenders. These FHA loans are then sold to GNMA - or Ginnie Mae - a government agency that packages - securitizes - the loans for investors. Ginnie Mae 'packages,' known as agency passthroughs - they pass through interest and principal payments to investors -, are backed by the full faith and credit of the U.S. government, meaning U.S. taxpayers. Fannie May - FNMA - and Freddie Mac - FHLMC - were privately chartered United States mortgage giants regulated by HUD.

 Without skin in the game, all management incentives favored greed rather than caution. The growth that extraordinary leverage made possible justified high salaries and generous bonuses for top management.

 

Because they were highly leveraged, they were extremely vulnerable to failure and would have been dependent on the highest lending standards but for their implicit government guarantees.

  Fannie Mae and Freddie Mac were private corporations, but they had been sponsored by the government and it was widely perceived that their obligations would be backed by the government. The implied government guarantees substantially reduced their borrowing costs, giving them a huge competitive advantage that enabled them to dominate their markets and grow into financial giants. Without skin in the game, all management incentives favored greed rather than caution. The growth that extraordinary leverage made possible justified high salaries and generous bonuses for top management. The guarantee implication proved correct when the government took them over in 2008 and provided many tens of billions of dollars so their creditors could be paid.
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  "Too big to fail means American taxpayers will pay for a bailout," Tavakoli points out. However, the government cares not for its taxpayers, so instead of requiring prudent lending standards, it actually encouraged looser lending practices to make home mortgages more widely available.
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  Fannie Mae and Freddie Mac provide money for the mortgage market by purchasing qualifying mortgages or guaranteeing them for a fee. Because they were highly leveraged, Fannie and Freddie were extremely vulnerable to failure and would have been dependent on the highest lending standards but for their implicit government guarantees. Tavakoli explains the common sense requirements of prudent lending standards that governed before the politicians decided that they knew better.

  "[The borrowers had to have] a good chance of paying off the loan: the borrower's income had to be verified and documented; total housing cost including insurance and fees -- no more than 28 percent of borrower's gross income; total debt - including credit cards, auto loans, etc. - less than 36 percent of borrower's gross income; the borrower's payment history could not include too many late payments. The borrower's money for the down payments and closing costs should come from his own savings, not from,, say, a 'gift' - which may in reality be a loan - from a relative. The borrower should have a steady job for at least two years, and enough extra cash to cover at least two months of all living expenses and other obligations."

  With the implicit government guarantees, Fannie and Freddie were able to pass their bond market savings on to mortgage lenders and the mortgage market without any expense for the Federal budget - until collapse caused losses of hundreds of billions of dollars.
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  To raise even more capital, Fannie and Freddie would package their mortgages and sell them on to investors as mortgage-backed securities. Not satisfied with the results of this flow of credit, politicians pressured Fannie and Freddie to loosen their mortgage lending standards so mortgages would become more widely available - especially to minorities and lower income people who were "subprime" credit risks. Alt-A mortgages are those extended to the higher levels of subprime borrowers.
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The Federal Reserve Bank kept interest rates extraordinarily low for extraordinary lengths of time providing fuel for bubble mania throughout the financial system.

 

Top management of the investment banks cared not since they were no longer partners personally liable for losses. In preparation for this high risk game, the investment bank partnerships had all become corporations. All the equity risks had been transferred to shareholders.

  Prudent standards for mortgage loans protect not only the lender, but also keep the borrower from getting in over his head, deter a variety of speculators and mischief makers, and protect the entire U.S. economy from disruption in this major financial sector. "The overall size of the U.S. residential mortgage loan market is around $1.1 trillion, of which a little more than 11 percent is subprime  and more than 10.4 percent is Alt-A."
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  However, the politicians and bureaucrats cared not. The government regulator, HUD, "stopped being part of the solution and became part of the problems." Fannie Mae and Freddie Mac management feared not and banked the salaries and bonuses justified by the profits from their reckless conduct. The Federal Reserve Bank kept interest rates extraordinarily low for extraordinary lengths of time providing fuel for bubble mania throughout the financial system.
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  Soon there was a new environment in the mortgage market. The housing market is illiquid in the sense that no two houses are exactly alike so there is no definitive "price." It is all too easy for mortgage brokers to induce assessors to overstate the value of a house. Then the brokers can lend to borrowers on the basis of the overvaluation. They cared not that the borrowers might have a hard time paying off the loan. The mortgage brokers and assessors earn fees and have "no skin in the game." They just sell the mortgages to Fannie or Freddie or a variety of investment banks that package the mortgages into securities for sale to investors.
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  Lending standards are thus dictated by Fannie and Freddie and the investment banks by the standards they apply for their purchases. However, they, too, didn't have "skin in the game" since there were investors who were willing to buy these mortgage-backed securities in reliance on the underwriters and the ratings provided by the ratings agencies. Top management of the investment banks cared not since they were no longer partners personally liable for losses. In preparation for this high risk game, the investment bank partnerships had all become corporations. All the equity risks had been transferred to shareholders. Even the creditors cared not, because they could rely on those implicit guarantees that government extended to the financial system. The ultimate victims, the taxpayers, were not consulted. In Washington, the taxpayers are a joke.
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  There were conflicts of interest at every step of the way, and moral hazard challenges to the ethical standards of agents who had no substantial skin in the game. Everybody was in reckless pursuit of the high fees, salaries, bonuses and yields available while the party lasted - and the regulators were looking the other way or even cheering them on so more credit could be allocated to the mortgage market.
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 Stock options:

  A popular form of bonus is the stock option. Stock options were considered a cost imposed directly on the shareholders rather than on the corporation.
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Stock options can be used to facilitate the milking of corporate assets. Revenue flows can be manipulated to produce surges in profits and share prices for the benefit of option holders.

 Stock options diluted shareholdings but were not reflected as a cost to the company since there was no way to precisely value them. Their value depended on whether and how far stock prices would rise above the option price. Supposedly, the options are worth this cost because they aligned management interests with the shareholder interest in rising stock prices.
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  Unfortunately, options can promote short term interests over a company's long term interests. Tavakoli explains the role that stock option abuse played in the mortgage madness.
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  Generous stock options based on short term results create powerful incentives for management to increase the likelihood of short term gains even if that means risking the corporation. This usually involves leveraging the corporation beyond prudent levels. The corporation can thus reap substantial profits during prosperous times, during which top management becomes independently wealthy on high salaries and cash and stock option bonuses. If the corporation later suffers a bad fall or collapses during an economic contraction, the shareholders and, perhaps, the creditors take the loss - along with the ordinary employees.
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  Stock options can be used to facilitate the milking of corporate assets. Revenue flows can be manipulated to produce surges in profits and share prices for the benefit of option holders. A major scandal involved scores of corporations that backdated options to reflect the lowest share prices during a business period to maximize the gains for the options.
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  Warren Buffett has advocated expensing stock options since as far back as the 1980s. This could only be based on approximate figures, but accounting is a nebulous art that is full of such approximations. A reasonable figure would immediately shed some light on the cost that options impose on shareholders. It would also show them as a cost to the corporation that reduced reported "earnings" on which bonuses are based.
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  The Financial Accounting Standards Board - FASB - decided to adopt a stock option expensing standard, but Wall Street, many conservative economists and influential Congressmen opposed the FASB and forced it to retreat. Finally, after the backdating scandal, the FASB did require the expensing of options. However, it didn't require mark-to-market accounting for them.

  All compensation provided in the form of shares and stock options should be in stock restricted for a substantial number of years to align management interests with the long term interests of the corporation. This would hardly be foolproof, but at least would require extra effort to game the system.

 Mortgage madness:

  The standard 30 year fixed rate mortgage backed by a substantial down payment and equity in the house and prudent lending standards was displaced by a variety of dodgy alternatives.
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  There were adjustable rate mortgages - ARMs - for terms as long as 45 years - with low initial teaser rates for the first few years. These comprised about 80% of 2006 loan originations. Even more attractive were interest only - IO - mortgages that depended on rising housing prices to increase the homeowner's equity in the home. There were "negative amortization" ARMs. They were called "liar loans" because nobody insisted on verification of the borrower's stated income. Initial payments actually didn't even cover interest costs. They, too, depended on rising housing prices to increase the homeowner's equity. Since the fees for such loans were higher than for standard full documentation loans, there was actually more incentive for brokers to create them than to create standard prudent mortgage loans.
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   The dodgy nature of the mortgage market became notorious.

  "The market made up pet names with catchy tags for this trash. NINJA loan: no income, no credit, no job, no documentation, no down payment, no problem. Get a loan and get in over your head. Liar loans will let us take your homes. You will choke your credit trying to pay back strangulation loans. (emphasis in original)

  By 2004, there were even NINA loans - no documentation, no income verification, no asset verification, no ratio of debt to income calculation - and SISA loans - dependent on stated income and stated assets without verification. The FHA guaranteed some of these loans and Fannie Mae and Freddie Mac bought them, pumping billions of dollars into the mortgage madness mill.
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It was Bush (II) administration policy to pump up the bubble even bigger and faster. The Federal Comptroller of the Currency countermanded state predatory lending laws over the unanimous objection of all 50 states.

  Since the generation of fees was the objective throughout the mortgage market, and there was no personal cost or risk for generating dodgy mortgages, it did not take long for the markets to attract the ethically challenged. The ranks of the mortgage brokers swelled. Unqualified borrowers were encouraged or assisted in submitting false documentation. Brokers employed appraisers  who provided the most liberal appraisals of home value. In little more than 18 months, 262 major mortgage lenders went out of business when the bubble burst - "an unprecedented failure rate." The FBI stepped in and charged 406 defendants with mortgage fraud in the year to June 2008 - but no Wall Street big shots were as yet among them.
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  Tavakoli compares the reckless investment practices involved in the Credit Crunch with the prudent practices of Buffett. By 2003, Buffett and the author, among others, were writing publicly about the mortgage market bubble (as was FUTURECASTS). However, it was Bush (II) administration policy to pump up the bubble even bigger and faster. The Federal Comptroller of the Currency countermanded state predatory lending laws over the unanimous objection of all 50 states. The stated objective was to increase minority home ownership by 5.5 million by 2010, but the usual unintended consequences of government industrial policy intervened.

  "When things got bad enough, investment banks stopped lending and the shaky mortgage lenders went bankrupt. Many investment banks were stuck with mortgage lenders' unpaid loans and with a warehouse full of bad subprime loans."

  With the Credit Crunch, minority home ownership is now lower than in 2002 and millions who have lost homes have also lost their credit. Tavakoli describes the carnage among the minority home purchasers who were the beneficiaries of this political brilliance.

  "Housing speculators and overreaching homeowners took risk, seemingly with 'eyes wide shut.' Many others were lured with the promise of homeownership. Predatory lenders targeted minorities and lower-income people who were intellectually and financially mugged, then dumped on the side of the road."

 The mortgage-backed securities bubble:

  The securitization of mortgages for sale to investors is a vehicle for increasing the mortgage money available for homebuyers and other real estate purchasers. However, without prudent lending standards by the mortgage originators or due diligence by the investment banks that bundle the mortgages into securities for sale to investors, it becomes a vehicle for abuse.
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Due diligence is as simple as not lending money to people who might not be able to pay you back.

  The incentives for abuse arise from the fees earned by each party along the way between the mortgage borrower and the ultimate investor. As long as there are investors willing to take the mortgage-backed securities, there is little incentive for due diligence among the intermediate parties. At the end of the day, they will have no skin in the game.
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  Buffett lost some money from this kind of abuse when a manufactured homes builder collapsed in 2002. He informed his legion of investors of this dangerous practice and posted the notice on his web site - years before the Credit Crunch. Neither the investment bankers and their investors nor the government regulators deigned to take notice of this warning from the world's most successful investor. In his annual shareholder letter, he wrote that the problem was "buyers who shouldn't have bought, financed by lenders who shouldn't have lent."
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  Tavakoli emphasizes that, no matter how sophisticated a debt instrument, valuation always depends on the likelihood that the borrower will be "good for the money." Finding out about that is what due diligence is all about. It's as simple as not lending money to people who might not be able to pay you back.
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  The mortgage-backed securities market became just a giant Ponzi scheme made credible by explicit and implicit government guarantees and government regulatory oversight that lulled investors into complacency. This "moral hazard" shredded market restraints on conflicts of interest abuses. With this government support, the market for mortgage-backed and other collateralized debt securities grew to involve trillions of dollars.
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  The dodgy mortgage-backed securities were based on overvalued houses and were worth just a minor fraction of their face value. Thus, all the fees that justified the high salaries and bonuses depended on finding new investors to pump in additional money to keep the housing market rising and the Ponzi scheme going. Fannie and Freddie were the primary participants, cheered on by the government. Why not? Only the taxpayers and shareholders were at risk.
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  By 2005, the financial press was full of articles blowing the whistle on these practices. "Financial professionals including Warren Buffett, Charlie Munger, John Paulson, James 'Jim' B. Rogers, William 'Bill' Ackman, William 'Bill' Gross, Whitney Tilson, Jim Melcher, David Einhorn - head of Greenlight Capital - myself, and others had been specific in sounding the alarm both verbally and in print for many years." However, the regulators at the Fed and SEC and other cognizant agencies remained determinedly unconcerned.
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The investment banks were actually "marking to myth," and they actually accelerated securitization activity through the first quarter of 2007.

  When housing prices began to slip, investment banks refused to mark down their inventory of increasingly toxic assets. That would have affected their capital ratios and cramped their activities. Instead of marking to market, they marked to models based on rosy assumptions. After all, there wasn't any market that could provide definitive prices (and there still isn't). The investment banks were actually "marking to myth," Tavakoli points out, and they actually accelerated securitization activity through the first quarter of 2007.
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Investors that were restricted to investment grade securities suffered massive losses when they were forced to sell securities that were no longer awarded investment grade status. Even when the interest payments continued, the principal was declining sharply. The ability to attract vast sums from investors who didn't appreciate the limited nature of the ratings kept the mortgage madness going. 

  The ratings agencies played a major role in the mortgage backed securities madness. They provided investment grade ratings - triple B or above - to some of these securities by dividing them up into segments - called "tranches" - with those segments bearing the risks of initial defaults and offering the highest yields rated lowest. Double A rated segments were thus protected by lower rated segments bearing the risks of the first 16% of defaults, and triple A rated segments had 24% protection - called "subordination." A super triple A segment had 70% protection.
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   The ratings agencies argue that they properly evaluated the yield risks and never evaluate pricing risks. Investors didn't understand that these ratings only applied to the risks of default. The ratings did not apply to the risks that the securities themselves would decline in price.
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  As subprime defaults ate through the lower rated portions of the securities, the ratings agencies began to massively downgrade the investment rated portions which thus declined in price by substantial amounts. Investors that were restricted to investment grade securities suffered massive losses when they were forced to sell securities that were no longer awarded investment grade status. Even when the interest payments continued, the principal was declining sharply. The ability to attract vast sums from investors who didn't appreciate the limited nature of the ratings kept the mortgage madness going.
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"A model will calculate the wrong answer to nine decimal places, but it cannot tell you it is the wrong answer."

  The weaknesses of ratings for derivatives and the mathematical models on which they are based are explained in some depth by Tavakoli. The short explanation is that the models and ratings are not based on actual examination of the corporations whose securities are the bases for the derivatives being modeled. The models and ratings are all based on data that becomes irrelevant during volatile times. Moreover, the data can be suspect to begin with. And the situation with respect to collateralized debt securities is even worse.

  "When a credit upset occurs in a financial sector, correlations that were previously fractional numbers tend to converge to one. Everything seems to fall apart at once. A model will calculate the wrong answer to nine decimal places, but it cannot tell you it is the wrong answer."

Using a single letter grade cannot cover both default and recovery rates and, during economic contractions, generally covers neither.

  Both default rates and asset recovery rates in the event of default are relevant for evaluating risk. A default where the underlying collateral retains significant independent value is obviously different from a default where there can be little recovery because it involves the collapse of the collateral. However, using a single letter grade cannot cover both default and recovery rates and, during economic contractions, generally covers neither.
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  The alternative approach is the professional analysis used by Buffett. He is not some mere technician tied to invalid mathematical models. He has a professional understanding that informs a professional analysis of risk for each business he is interested in. He is thus able to profit when Wall Street firms rely on their mathematical models and thus misprice risk. Tavakoli provides some examples.

  "Investment banks could put on the same trades [as Buffett] if they did fundamental analysis of the underlying companies, but they are too busy playing with correlation models. Banks and investment banks have become invisible hedge funds putting risk on their balance sheets that they cannot quantify. Meanwhile, Warren Buffett models the risk in his head and profits."

  Berkshire Hathaway is the corporation run by Buffett. Being an insurer, it makes money not only on the mispriced risks it accepts at realistic prices but also on the sizable premiums it has the use of before any of the insured risks eventuate. 
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 Hedge funds:

Investment banks suddenly stopped buying mortgages from mortgage brokers. 

  The houses of cards began to crumble when housing prices began to slip in the summer of 2007. Bear Stearns Asset Management hedge funds were major participants in the game, and now began collapsing. Investors began to shun collateralized debt securities of all kinds. Mortgages began to pile up in investment bank hands so the investment banks suddenly stopped buying mortgages from mortgage brokers. 
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Few hedge fund managers are worth anywhere near the outsized salaries and bonuses that they take from their funds. Moreover, the field is full of hype and outright fraud. Returns are routinely misrepresented.

 

"Multiyear returns are rarely dollar weighted, so returns are overstated, because large slugs of new money are earning lower returns. As the fund grows, it is harder to make excess market returns, since it is harder to find those incrementally attractive new ideas."

  There are only a few hedge funds that live up to their hype or justify their outsized management fees, Tavakoli explains. Annual fees can be as much as 2% to 5% of assets plus 20% to 44% of the profits for any profitable year. Clearly, there is great incentive to leverage bets and take outsized risks to achieve a highly profitable year. In addition, they charge administrative fees of about 0.5% per year and engage in such dubious practices as trading "soft dollars" for research from investment banks, lending money from fund assets for the personal use of fund managers, and commingling fund assets with broker assets.
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  Worse is the additional management layers for investments with fund of funds outfits. They charge about an additional 2.5% load, 3% for annual expenses and 25% of any annual profits. They also insist on a substantial waiting period whenever investors decide they want their money back.
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  Few hedge fund managers are worth anywhere near the outsized salaries and bonuses that they take from their funds. Moreover, the field is full of hype and outright fraud. Returns are routinely misrepresented.  They brag that they can make money whether the market goes up or down, but 2008 was a bad year for hedge funds. Caveat emptor!

  There were over 7,600 hedge funds in 2007, almost 1,000 of which have failed. Averaged losses in 2008 were about 19%, but gains in early 2009 were about 10%.

  Tavakoli uses 25 pages to demystify hedge funds. After costs and fees, few hedge funds will consistently outperform the market. Being highly leveraged, many soar during prosperous times - and crash and burn during economic contractions. Since those that crash and burn are no longer included in hedge fund averages, there is "survivorship bias" that makes hedge funds as a group look deceptively attractive. There is also "creation bias." Only funds that hit it big at the beginning attract billions in new investments. Those that suffer failure right at the beginning are never reported. Moreover, those that do hit it big at the beginning are seldom as good as they seem thereafter.

  "The initial outperformance has a halo effect on later years since the long-term record will continue to carry its swelling effect, even if subsequent returns are mediocre. As more money flows in, the funds often cannot replicate outperformance, devolving into underperformers. Multiyear returns are rarely dollar weighted, so returns are overstated, because large slugs of new money are earning lower returns. As the fund grows, it is harder to make excess market returns, since it is harder to find those incrementally attractive new ideas."

  Investment banks and prime brokers affiliated with banks lend vast sums to hedge funds on margins of as little as 10%. They receive big fees for these loans so they try not to think of a large hedge fund borrower going broke. The fees were so good that investment banks began encouraging and facilitating hedge fund startups and operations. They provided office space, back office clearance, accounting, legal support, marketing support, and even invested seed capital. Their prime brokers might provide financing for leverage, set up custody accounts, act as settlement agent, and prepare accounting statements. They might even provide risk management and trade ideas.
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  Similar fees could be earned from structured investment vehicles - SIVs - and collateralized debt obligations - CDOs - so investment banks encouraged them with loans, assistance and even staff.

  "Undercapitalized managers are easily influenced by an investment bank that sets them up in business and trades with them. If an investment bank has a large inventory of overrated and overpriced mortgage loan or leveraged loan-backed securities that it needs to get off of its books, it is very convenient to have symbiotic relationships with structured investment vehicles, collateralized debt obligation managers, and hedge funds. As investment banks needed to get bad loans off of their balance sheets, institutional investors became the prey of both hedge funds and investment banks.

  Buffett avoids leverage. He does not reach for the big returns that leverage makes possible. Instead, he assumes responsibility for sheltering shareholders "from leverage's swift and painful downside."

  "Most hedge fund managers happily load up on risk to stay in the game. Hedge fund wisdom is 'heads I win, tails you lose, and I still win -- just not as big.' There is one other possibility: The coin can stand on edge -- the hedge fund manager gets bailed out, and you give back your winnings, but we will get to that later. For now, winning means that a hedge fund's returns are up, managers collect hefty fees while attracting new money, and investors get a reasonable return on their money. Losing means that hedge fund managers still make hefty fees and investors have a negative return or perhaps even lose all of their money. The hedge fund manager hates to lose, since he will not be able to attract new money and the money, upon which he gorges, will shrink, thus decreasing his payday."

 Collateralized debt obligations:

 Collateralized debt obligations - CDOs - vary widely in depth and complexity. They may involve one layer of one type of debt - like mortgage-backed securities - or may be multi-layered beasts combining many types of debt of opaque complexity.
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There is, of course, a steady flow of legitimate CDOs used to bring in funds for legitimate purposes. Into this flow it is easy for a financial institution to dump its trash.

  There are CDO deals and CDO squared deals, and CDO cubed deals. Mortgage loans, credit derivatives, asset-backed securities, mortgage-backed securities, other CDOs, hedge fund loans, credit card loans, auto loans, bonds, leveraged corporate loans, sovereign debt, etc., can be bundled together in various ways.
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  Each asset and each layer of the CDO comes with its own prospectus, so a single large multi-layered CDO can have thousands and even hundreds of thousands of pages of prospectus. Since nobody can know all the pertinent details, investors have to rely on the reputations of the investment banks that underwrite the CDOs and the rating agencies that rate them, but all too often all the investment banks and rating agencies are interested in are the fees they get for the deal.
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  There is, of course, a steady flow of legitimate CDOs used to bring in funds for legitimate purposes. Into this flow it is easy for a financial institution to dump its trash. It can mix its own trash with trash it buys from other financial institutions so the deal looks like an arms length transaction. Include some good CDOs and it can be cut up in portions some of which the rating agency can give investment grade ratings to. With a full range of ratings, it can look legitimate.

  "Now you have deniability. After all, why would you buy someone else's CDOs if they were toxic? Now get the compliant rating agencies to rate a huge chunk of this risky hairball triple A. If you are lucky, you may find an investor to buy it. Failing that, you may find a bond insurer to insure it. Failing that, you may find a vehicle or hedge fund willing to do a credit derivative or other leveraged transaction. These diversions should get you through bonus season. After all else fails, your investment banks can beg the Federal Reserve Bank to take overrated AAA paper in exchange for treasuries."

The purchasers rely on the ratings and the reputations of the underwriter to satisfy their due diligence obligations because these investment managers do not really understand what they are buying. 

  These CDOs are sold to institutional investment managers. The purchasers rely on the ratings and the reputations of the underwriter to satisfy their due diligence obligations because these investment managers do not really understand what they are buying. They aren't really worried about risk, either, because they are playing with other people's money. They are attracted to the higher yields on offer that justify their high salaries and bonuses. Thus, when the bubbles burst, mutual funds, pension funds, bank portfolios, insurance companies, local government funds, private investment groups all lost billions. They were shocked - shocked -  that investments they didn't understand failed to fulfill expectations.

  "In some deals, all of the tranches below the senior-most triple A will lose the entire principal amount, and the senior-most Triple A will lose substantial principal."

  Inevitably, the market turned against CDOs, so the investment banks came up with structured investment vehicles called "SIV-lites." They had less protection than ordinary SIVs. Into these SIVs were dumped the overrated AAA tranches of CDOs which the rating agencies duly rated AAA so that they could support AAA rated commercial paper. But they were backed by subprime debt. Inevitably, when the underlying subprime debt suffered massive downgrades and price declines, the SIVs declined with them.

  "The moral hazard swamped any risk the rating agencies' models could capture. One investment banker crowed to me that the rating agencies are eager for fees and the investment bank's structurers seeking ratings for their CDOs are 'shrewd bullies.'"

 Regulatory failure: 

 

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 The income statements of Merrill Lynch and the big investment banks were several quarters late in recognizing their losses - and the SEC did nothing about it. The reporting was "Enronesque," Tavakoli stated publicly at the time. The government was occupied in spreading white wash.
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"The direct and indirect costs to the U.S. taxpayer will be difficult to assess because of creative accounting that delays the recognition of the true problem."

  Government enforcement efforts were initially restricted to the small fish. However, deceptive practices civil suits are being directed at some of the Wall Street big shots who grew wealthy while they impoverished their firms and shareholders, and enforcement actions against some of them are in the works.

  "The direct and indirect costs to the U.S. taxpayer will be difficult to assess because of creative accounting that delays the recognition of the true problem. For example, banks and thrifts announced they were delaying their recognition of losses by allowing delinquencies of up to 180 days before taking a writedown on loans, and Fannie Mae and Freddie Mac said that in the past they wrote down loans when they were 90 days past due, but sometime in 2008 they decided to wait two years." (emphasis in original)

"Rating agency models do not capture these huge risks, yet the rating agencies never seem to refuse to rate these deals."

  Ultimately, investment banks such as Merrill Lynch, Citigroup, Calyon, Lehman, Bear Stearns, Credit Suisse were stuck with billions in unsold CDOs. Not to worry! They bought "bond insurance," obtained credit protection from hedge funds, and engaged in a variety of leveraged sales. However, ultimately, as failures multiplied, the entire market shut down for legitimate as well as risky investment vehicles. It was just too difficult to distinguish the one from the other. Not to worry! The investment banks could still get their buddies at the Federal Reserve to take their overrated AAA paper.
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  Tavakoli tells us that Buffett doesn't invest in anything he doesn't understand. He does not try to juice up yields with leverage.

  "If you are not leveraged, and your businesses generate enough cash to meet your expenses, you do not have to worry about what anyone else thinks of your financial situation. You never have to sell assets into a distressed market to raise money, and if the stock market closes for years, you do not need to worry, since your assets keep growing and generating value."

  Berkshire Hathaway bent during the Credit Crunch. Indeed, it bent pretty severely. However, it did not break. It is in a position to recover as the economy recovers.
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  FUTURECASTS is always highly optimistic about long term economic prospects for the U.S. and considers fears about a return of the Great Depression evidence of economic ignorance. However, those who ignore the business cycle are equally ignorant. For more than  a decade FUTURECASTS has been repeatedly warning: "Prudence always dictates that we be prepared for a recession as bad as that of 1980-1982."
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  Any management that does not operate on that basis has failed its prudence and due diligence tests. Their entities deserve to fail. They - and those foolish enough to invest with them or extend them credit - should not be bailed out. The right to fail is as important for capitalist markets as the right to succeed.

   Both Buffett and Tavakoli were aware that "the market was overleveraged, rating agencies misrated debt, and investment banking models were incorrect." They - and several other professionals - knew that credit derivatives contributed to the excess leverage. Buffett's periodic shareholder letters - available on his web site - "told investors everything they had to know about overpriced securitizations." This was no mere child shouting that the securitization king was naked. Nevertheless, the "authoritative" people - in Wall Street, Washington and the economics profession - went right on admiring the economy's sartorial splendor.

  "[The] CDO managers are unregulated, and only a handful of managers provide good value for the fees charged. Most do not have the expertise or resources to perform CDO management or surveillance. Many cannot build a CDO model. Many managers rely on the bank arranger both for structuring expertise and to take a lead role with the rating agencies to secure the initial ratings. Rating agencies rarely ask for background checks on CDO managers.

  The Fed bailed out the reckless bond insurance companies like AIG so that the insurers could make payments to investment banks on their reckless insurance contracts. It wasn't AIG - the insurer - that the Fed was protecting. Ultimately, the money provided to AIG simply flowed through to the large investment banks that should have been smart enough to know their insurer was covering more of a single type of high risk security than it could handle if that risk ever eventuated. Not to worry! It's only taxpayer money, and meanwhile everybody banked those large salaries and bonuses. The losses, much of which are being picked up by the taxpayers, have exceeded $1 trillion.

  Moral hazard and conflicts of interest permeate these deals.

  "Conflicts of interest do not mean that there is anyone doing anything wrong, but when the moral hazard is enormous, things never seem to end well for investors. Rating agency models do not capture these huge risks, yet the rating agencies never seem to refuse to rate these deals. I have written books and articles on this problem for years; the ratings on deals with this kind of risk are totally meaningless. Yet the rating agencies continue to defend their indefensible methods."

  Buffett provides a simple guide to investment management ethics. You of course start with what is legal, but you also restrict yourself to what you would feel comfortable with if it were printed on the front page of your local paper. Those who cut corners are doing it for their own benefit, not for your benefit or the benefit of their other investors.
 &
  The stock of Moody's Corp., one of the big three rating agencies, rose almost 700% in about eighteen months to the end of 2006 "due chiefly to revenues generated from rating structured financial products." In 2007, its stock price gave back about 50% due to the developing credit crunch.
 &

 Ratings:

 

&

  The rating agencies work on the basis of statistical probability of default and estimates of expected loss, Tavakoli explains. They are not auditors or investigators. They adamantly insist that they "are not empowered or able to unearth fraud."
 &

"They take data at face value, slap a rating on a dodgy securitization, and pocket a fat fee."

 

Equity capital is flexible enough to bend without breaking, debt capital is inflexible and shatters like glass.

  They are thus dependent on the information disclosed to them and on their statistical models. It is the deal sponsors and investment bank underwriters that are responsible for due diligence - but the rating agencies did not even demand evidence that this due diligence was properly performed.  

  "In the mortgage loan securitization market, a statistical sampling of the underlying mortgage loans should verify: integrity of the documentation, the identity of the borrowers, the appraisal of the property, the borrower's ability to repay the loan, and so on."

  All this is essential to understand the character of the risk being modeled. Obviously, new financial instruments with new risk characteristics can't be modeled on the basis of old data on existing instruments. Lacking data on the new instruments or the track record of the instrument managers, the ratings become meaningless guesswork
. &
  In the three decades before 2007, fewer than 0.1% of the 26,000 structured securities originally rated AAA by S&P subsequently defaulted. However, the game was radically changing in recent years, and the rating agencies failed to change with it. The carnage among deals underwritten in 2005 and thereafter is "unprecedented."

  "The rating agencies protest they are misunderstood rather than miscalculating when it comes to rating structured products. They claim the market misapplies ratings by expecting ratings to indicate market price and liquidity, but the former are merely symptoms of the real problem. They take data at face value, slap a rating on a dodgy securitization, and pocket a fat fee."

  There is an obvious difference between corporate securities and securitized debt obligations. If corporate earnings fall and corporate stock prices decline, a good corporation can always bounce back. However, if earnings for a CDO fall, it means it has suffered some defaults, and those will never recover. Equity capital is flexible enough to bend without breaking, debt capital is inflexible and shatters like glass.
 &
  When debt obligations are securitized, they are often leveraged 20-to-1 or 30-to-1 or even 40-to-1 and thus exist on a narrow precipice. The credit crunch quickly wiped them out in large numbers - and sometimes wiped out their creditors, too. When a hedge fund collapses, the investment banks that lent it money quickly take back the collateral - which often consists of a vast array of the hedge fund's toxic illiquid assets.
 &
  The regulators at the SEC, the Fed and the Bank for International Settlements, and a host of private contracts, remain dependent on these ratings for their regulatory purposes. This provides the ratings agencies with a lucrative oligopoly franchise and protection from attack.
 &
  Even before the Credit Crunch, highly rated "investment grade" securities periodically suffered collapse. Investors must do their own due diligence or hire advisers who can do it for them or confine their investment to underwriters that can be trusted. Recently, many advisers and underwriters failed to live up to their obligations. The author mentions failures of investment grade securitizations backed by credit card receivables, manufactured housing loans, metals receivables, furniture receivables, subprime mortgages, movie receipts, among others. This failure of due diligence should be the basis for SEC investigations of the investment banks. So far, there have been some high level resignations and job loss, but enforcement efforts are just in early stages.

  There is no need to worry about unemployment problems here. These people have valuable experience at gaming the system and have no trouble finding new high level positions with other Wall Street firms.

 Bear Stearns:

 

 

&

  The big dominoes began to fall. Countrywide, Indy Mac, Washington Mutual had plunged wildly into the subprime mortgage madness. The Federal Deposit Insurance Corp. had to dig deep into its $53 billion deposit insurance fund, but it is one of the bank regulators along with the Office of Thrift Supervision that failed to regulate lending standards and so deserves its problems. The Credit Crunch was on and the taxpayer was about to get clobbered.
 &

When the collateral of one of the Bear Stearns hedge funds was seized and put up for sale, the low prices on offer were staggering. Disclosure would have demonstrated huge losses for the lenders, but there was determined effort to ignore them.

  The loose investing practices at Bear Stearns and its numerous hedge funds are explained at some length by Tavakoli.
 &
  By the middle of 2007, Bear Stearns' creditors - Citigroup, Inc., J.P. Morgan Chase & Co., Merrill Lynch & Co., Morgan Stanley, Goldman Sachs Group, Inc. Barclays PLC, Dresdner Kleinwort, Deutsche Bank, among others - were calling for additional margin as the value of collateral plummeted. When the collateral of one of the Bear Stearns hedge funds was seized and put up for sale, the low prices on offer were staggering. Disclosure would have demonstrated huge losses for the lenders, but there was determined effort to ignore them. Bear Stearns "was the first to show everyone's losing cards."
 &
  The hedge funds collapsed, but top Bear Stearns management had made hundreds of millions of dollars in the years before the collapse. Hedge fund managers, too, had made huge sums, but some were indicted for securities fraud. The little fish found themselves immediately vulnerable.
 &

  A variety of over-leveraged hedge funds bet the ranch on the basis of market models created without understanding of the underlying collateral. However, market research tells you nothing. Only fundamental analysis of the underlying assets compared with the market price reveals "fair value." This is the heart of the Benjamin Graham approach to investing followed by Warren Buffett. Buy a stock when it is below its fair value and sell it when it is above its fair value, determined after careful analysis.
 &
  There were spectacular collapses as the meager market value of dodgy collateral was made manifest. Some of those collapses are set forth by Tavakoli. The troubles of the hedge funds quickly became the troubles of the investment banks that backed them, like Bear Stearns and Carlyle Capital. However, in March 2008, the Fed came to the rescue of Carlyle Group and other investment banks and major equity firms. It began accepting triple A mortgage backed securities for discount at 95 on the dollar. Hedge funds went under but the well connected Carlyle Capital Group sponsor survived.
 &
  However, not Bear Stearns. As March 2008 proceeded, the market was demanding 3% more collateral for highest grade mortgage backed bonds such as those issued by the increasingly troubled giants Fannie Mae and Freddie Mac. Alt-A backed bonds now needed 30% more collateral. Market funding dried up. The Fed would not take Alt-A securities, and its emergency Term Securities Lending Facility - TSLF-  for triple A securities was slow getting started. Suddenly Bear Stearns had no friends. Clients pulled billions out of their Bear Stearns trading accounts.
 &

Highly leveraged with huge bets on illiquid assets that had no clear market value, investment banks were vulnerable to any loss of confidence in their solvency. The short term financing on which their operations were based could disappear in a flash.

  The Fed was designed to protect banks, Tavakoli points out, not nonbank investment banks and nonbank primary dealers. However, well connected Wall Street interests needed help and the Fed was riding to the rescue. After all, it's just taxpayer money, and the Fed can print up as much as needed.
 &
  Highly leveraged with huge bets on illiquid assets that had no clear market value, investment banks were vulnerable to any loss of confidence in their solvency. The short term financing on which their operations were based could disappear in a flash. "In fact, the investment bank itself may not know whether or not it is solvent," the author points out. Buffett avoids leverage, she notes, so he is never threatened by occasional panics on Wall Street.

    "By supplying investment banks with liquidity, the Fed introduced huge moral hazard. The Fed rewarded those who brought down the housing market."

  Tavakoli worries that even the Fed can become overextended, undermining faith in the dollar. That can happen, but the world needs the dollar as a reserve currency and that gives the Fed huge - but not unlimited - scope for meeting crises with newly created money. The Fed has in fact more than doubled the basic money supply this last year.
 &
  As FUTURECASTS has pointed out, the test will come as economic recovery begins and the financial system recovers its ability to multiply the purchasing power of all that new money. Inevitably, as in the 1970s, price inflation will surge before employment levels recover, making it difficult for the Fed to fight on both fronts.
 &
  The one encouraging note is that, unlike in the 1970s, at least there has been repeated acknowledgement of the existence of this problem from both the Fed and administration officials. Their rhetoric seems to be preparing the public to accept the slow "jobless" recovery that would be the result of the high real interest rates that will be needed to maintain the strength of the dollar on which all else depends. Since the initial surge, expansion of the money supply has practically stopped. The Fed and Treasury continue to guarantee against financial system collapse, but generally seem to be content to let the markets work their vicious way out of the various system bubbles. Considering the extent of these problems, this is occurring with remarkable rapidity.
 &
  However, the taxpayer is losing massively. The Fed is buying $1.25 trillion in high grade mortgage backed securities and has purchased about $160 billion in government bonds as it frantically monetizes long term debt to constrain interest rates. It is purchasing $200 billion in Fannie Mae and Freddie Mac debt. The loss to the Fed on this "quantitative easing" is already about $5 billion. However, the Fed, too, does not mark to market. It will probably hold on to these securities for the many years until they mature to avoid having to admit its losses. Fortunately, major business media like the Wall Street Journal are all over this story, so FUTURECASTS need not spend much time on it.
 &
  However, nobody is focusing on Obama's role, here. It remains to be seen whether Obama will provide the needed leadership. He will have to spend political capital supporting policies that will initially result in a slow growth recovery with considerable residual unemployment. Spending restraint from Congress would surely help, but that is too much to hope for. Nor does Bernanke's record provide reason for confidence. He has always exhibited a cavalier attitude towards the purchasing power of the dollar.

  Ultimately, J.P. Morgan Chase was induced to buy Bear Stearns and its toxic assets for $2.2 billion - or $10 per share - and a $30 billion Fed facility for some of Bear Stearns' riskiest assets. J.P. Morgan Chase was also at risk for $1 billion of Bear Stearns losses. The author discounts the Fed's apocalyptic explanations for brokering the bailout and argues that a bankruptcy would have been better, like that involving Drexel Burnham Lambert twenty years earlier. (There is no comparison between the risks of financial contagion then and now.)
 &

 Nationalizing the losses:

  The collapse and Federal takeover of AIG, Fannie Mae and Freddie Mac at huge and continuing expense in the hundreds of billions of dollars came in September, 2008. Tavakoli tells about the maneuvers and personalities involved.
 &
  The government took over these fallen giants and replaced management with experienced Wall Street hands. Many of these replacements, however, had been involved in prior regulatory and management failures. Moody's rating for AIG was in decline, but still at investment grade single A when it was taken over by the Federal government.
 &
  However, AIG was an insurer. It had been making money on $441 billion of credit default protection for the risky bets of JPMorgan and Goldman Sachs and similar outfits worldwide. With all of these bets going south at the same time, there was no way AIG could cover its credit default insurance obligations, and that put Goldman Sachs and JPMorgan, among others, at risk.
 &
  The Fed would not let that happen to its Wall Street buddies. It rushed in with an $85 billion line of credit to back AIG in exchange for interest payments and stock warrants for almost 80% of AIG. Treasury Secretary Hank Paulson and a solid lineup of Wall Street leaders supported the AIG bailout. After all, the money flowed right through AIG and out to them pursuant to their credit default insurance agreements. (And Goldman Sachs and Morgan Stanley would virtuously be able to maintain the fiction that they did not need a Federal bailout.)
 &

Institutions need only put up some small portion of  their illiquid assets for sale to see what they will bring, so there is no excuse for this retreat from mark to market standards. 

  The SEC retreated from its mark-to-market accounting requirements in March 2008. Because of the tough market conditions, it permitted assets to be marked to models. This, Tavakoli asserts, is really a "mark-to-myth" standard. If there is no market, institutions need only put up some small portion of  their assets for sale to see what they will bring, so there is no excuse for this retreat. Soon, Goldman Sachs, Morgan Stanley, Merrill Lynch and similar institutions were increasing their mark-to-model accounting category by many tens of billions of dollars.
 &

  Lehman Brothers began a feverish deleveraging campaign in 2008, selling $130 billion in assets and raising $12 billion in new capital - but even that reduced its leverage only from 31.7 times to 25 times. It wasn't enough.
 &
  When no more lenders or buyers could be attracted - and even the Fed declined to offer a bailout - it went bankrupt in September, 2008. Its assets, including those of its clients and creditors - were frozen pending the difficult and painful liquidation process. Just before the bankruptcy, Merrill Lynch concluded a hurried deal by which it sold itself to Bank of America for $29 per share in an all stock deal. The Bank of America stock soon plummeted to single digits under the weight of the Merrill losses. (This troubled transaction was completed under Fed influence, and the results unfolded after this book went to press.)

  "By October 2008, JPMorgan acquired Bear Stearns and Washington Mutual; BofA acquired Merrill; and Wells Fargo acquired Wachovia. Morgan Stanley and Goldman Sachs became bank holding companies. The Treasury invested tens of billions of dollars in each. AIG got a bailout. Lehman was bankrupt. The situation is fluid. Meanwhile, Berkshire Hathaway has limited debt - leverage - and a lot of cash."

 Bond insurers:

 

&

  Bond insurers, too, succumbed to the moral hazard and conflicts of interest underlying the Credit Crunch. Bond insurers earn a reasonable return for the useful service of insuring municipal bonds. This facilitates the financing of local government operations for weaker municipalities that suffer from low credit ratings.
 &

  However, some of the bond insurers simply couldn't resist the fees on offer for insuring subprime home equity loans. Unfortunately, they have nowhere near the funds needed to pay off on their insurance obligations in the face of the wholesale carnage of the Credit Crunch. They, too, had an overconfident outlook on home mortgage obligations and remained determinedly blind to the blossoming housing and mortgage bubbles. The protection offered by this "insurance" was thus fictitious - unless the taxpayers could be stuck with the losses. Why not?
 &
  Insured municipal bonds were sold through periodic auctions.
These bonds were thus called "auction rate securities." The auctions magically transformed these long term obligations into short term obligations which, with bond insurance guarantees in hand, could be floated with a considerably lower interest rate than similar long term bonds.
 &
  In February 2008, banks and investment banks stopped bidding for auction rate bonds and the $330 billion municipal bond auction-rate securities market froze. Municipalities were faced with having to refinance into fixed rate debt with significantly higher rates. It was a major financial mess.

  "Even pension funds invested in these 'AAA money market' securities. These assets are 'guaranteed,' but many bond insurers are in trouble, so their 'guarantee' is not worth anything. In some cases the underlying assets seem sound - so the 'guarantee' does not matter -, but in other cases there is a genuine risk of principal loss and the guarantee people depended on is worthless because 'sophisticated' bond insurers guaranteed bad products manufactured by investment banks. (emphasis in original)

  Many banks and investment banks have paid fines to settle enforcement actions and have agreed to buy back the auction rate securities at full price. There are obvious conflicts of interest with retail customers that have led to civil suits.
 &

If the insurance was no good, major banks and investment banks would have to take huge losses on their insured toxic assets.

 

If the bond insurers failed or lost their triple A ratings, a flood of risk would pour back into investment bank balance sheets.

  The alarm was being sounded by many securities industry professionals in 2007, but Standard and Poor's persisted in rating the largest bond insurers triple A throughout the year. If the insurance was no good, major banks and investment banks would have to take huge losses on their insured toxic assets. Pressure was put on the investment banks to come up with money to help the insurers. After all, the investment banks had the due diligence obligations for these transactions and had clearly failed to fulfill those obligations with respect to the insured toxic assets. If the bond insurers failed or lost their triple A ratings, a flood of risk would pour back into investment bank balance sheets.
 &
   By the middle of 2008, this fiction could no longer be sustained. The major bond insurers were losing their essential triple A ratings, several crashing all the way below triple B to junk. There are lawyers who will have full and lucrative careers litigating this mess. Moody's announced that it was revising its ratings methods for municipal bonds.
 &
  Among other things, the ratings agencies had been looking at revenue streams from insurance premiums rather than evaluating whether those premiums would exceed the default losses plus expenses. Since premiums come in first, sometimes years before the losses from defaults, it's easy to generate increased premium revenues and reserves by underwriting risk at too low a price. This in essence is what the bond insurers had been doing when insuring bonds and structured finance instruments against default. This permitted the insurers to chalk up big profits justifying high salaries and big bonuses - until the business cycle made the risks real and collapsed the houses of cards.
 &
  Berkshire Hathaway is in the insurance business, Tavakoli reminds us. However, it confines itself to "premium business at premium prices." Buffett only insures risks that he understands. He never simply chases revenue streams.
 &
  When the municipal bond market auction failed in the second week of February, 2008, Buffett stepped in to provide backup insurance against the possibility that the original insurers would not be able to pay. The premiums that Buffett charged for this backup insurance were about twice those received by the primary insurers.
 &

 Government policy failures:

  The government has played a major role in creating the financial bubbles of the Credit Crunch, Tavakoli points out. It is the government, after all, that creates moral hazard.
 &

"Cheap money fueled bad lending, including predatory lending, and cheap money expanded the housing bubble."

 

The Fed is now discounting long term and illiquid assets that it will never be able to liquidate except at a steep loss.

 

The Fed is now a backstop not just for the banks but for the entire financial system - and it has no regulatory authority except for the banks and collects no fees for this service.

 

Unlike deposit insurance, there is no fund maintained to cover losses. It is the taxpayers that bear all the expenses for these government guarantees, while those who indulge in reckless activities reap the rewards while they are successful. 

  The Credit Crunch recession is primarily the result of poor (indeed stupid) government policies rather than market failure. Among many other things:

  • Washington is failing at maintaining the purchasing power of the dollar - one of its primary responsibilities..

  "For most of this century, Washington has pumped money into the economy by keeping interest rates low. Easy money tempts crooks. Speculators and fraudsters had a party. Regulators became enablers. Cheap money fueled bad lending, including predatory lending, and cheap money expanded the housing bubble. - - - Bailouts of poorly regulated investment banks and corrupt mortgage lenders mean Washington is printing more money, which weakens the dollar. Inflation adds to the misery. Americans feel poorer."

  The dollar is a strategic weapon of vast importance. Given the standoff in nuclear and conventional forces, the dollar was arguably the determining factor in the Cold War. As long as the dollar is the world's premier hard currency, the United States has the ability to a significant but not unlimited extent to print gold. By its rapid expansion of the money supply, the U.S. government risks loss of the dollar's reserve currency status. This would be a loss of vast proportions.

  "We now shovel $2 billion per day out the door and into the pockets of the rest of the world. It is as if we have a large lot of land and are selling off the fringes of our gardens so we can buy more consumable goods for the house."

  • Fannie Mae and Freddie Mac were at the heart of the mortgage madness bubble, but Congress in its usual ham handed manner is eager to double down on this losing bet. Instead of reestablishing sound lending standards, Congress is eagerly trying to reflate the housing and mortgage bubbles by pumping tens of billions of dollars through Fannie Mae and Freddie Mac. These government sponsored entities were leveraged at 50-to-1 and were supposed to support the mortgage market at no cost to the taxpayers.

  "Fannie Mae and Freddie Mac have been pressured to help other lenders out of the mortgage mess. Fannie Mae and Freddie Mac guarantee approximately 40-45 percent of the $11.5 trillion U.S. residential mortgage market. As of March 31, 2008, Fannie Mae and Freddie Mac had combined debt of $1.6 trillion and credit obligations of $3.7 trillion. This is a total of $5.3 trillion, roughly the same as U.S. government bonds. The U.S. government took over Fannie Mae and Freddie Mac on September 7, 2007, and this is the problem that will probably cost taxpayers the most. The government is in charge of financing most of the U.S. mortgage market, and the mortgage market is still under regulated." (emphasis in original)

  The Federal Housing Administration - FHA - is up to its elbows in the bubble reflation effort. Nearly 1/3 of new mortgages are insured by the FHA. Its new limits are about $700,000. Down payments need only be 3.5%. This is 100% insurance, so only the taxpayers have skin in the game. Mortgage origination fees are 2% to 3%, so originators are shoveling them out the door. Unsurprisingly, defaults are rising, so the FHA is likely to need a bailout in the tens of billions of dollars. Congress, in  its infinite wisdom, is again pressuring banks to lower mortgage lending standards.

  • "Washington failed to regulate mortgage lenders, and regulators failed to regulate themselves."

  • The Fed is now discounting long term and illiquid assets that it will never be able to liquidate except at a steep loss.  The Fed's bailouts are costing billions and are increasing moral hazard. Traditionally, the Fed provides "liquidity" during a crisis by discounting short term high grade but temporarily illiquid assets that it can liquidate at a profit after the crisis is over. However, with long term debt obligations, there are real risks of substantial price declines as interest rates rise. Not to worry! It's only taxpayer money.

  • Imprudent practices will again blossom as the economy returns to prosperity.

  The Fed responds to moral hazard complaints by pointing out that the shareholders of the financial institutions it has bailed out have lost big, and that top management are typically major shareholders. However, the chief beneficiaries of the bailouts are the creditors that recklessly chased yield up the risk curve and enabled the investment banks and hedge funds to operate recklessly at 30-to-1 or 40-to-1 leverage levels. These same leverage levels enabled management to bank big salaries and bonuses. Thus: 

  "As long as Wall Street enhances revenues with leverage to prop up kingly bonuses, as long as there are few personal consequences for CEOs - and board members and other top executives - for shoddy risk management, as long as CEOs are allowed to walk away with millions, nothing will change. The fact that shareholders are wiped out is no deterrent, and moral hazard will live on. I see nothing that will change that in the future. In fact, just the opposite. We have handed out hundreds of billions of dollars in taxpayer dollars and have put hundreds of billions more at risk without demanding effective conditions." (The early signs of renewed bubble mania are already observable.)

  • The Fed is now a backstop not just for the banks but for the entire financial system - and it has no regulatory authority except for the banks and collects no fees for this service.

  Tavakoli correctly insists that it was vital to let these overextended institutions fail. (The right to fail is as important as the right to succeed for capitalist markets.) Moreover, the bailouts have not as yet come with appropriate regulatory strings and expenses. There is really nothing to prevent similar conduct in the future. Unlike deposit insurance, there is no fund maintained to cover losses. It is the taxpayers that bear all the expenses for these government guarantees, while those who indulge in reckless activities reap the rewards while they are successful.

  Even General Motors ultimately was not "too big to fail." It is vital to establish a procedure for the orderly liquidation or restructuring of major financial institutions. Fannie Mae and Freddie Mac should be liquidated so mortgage interest rates can return to a normal level, but Congress cares not for the taxpayer and keeps shoveling money through these entities.

  • Of all the regulators, the SEC had the broadest responsibility and authority for preventing the deceptive securitization practices that are at the core of the mortgage lending crisis.

  "How do we explain the SEC's poor reaction time to the securitization problems at the investment banks it regulates? Could the SEC's conflicts of interest have anything to do with it? Former SEC staffers often seem to land very lucrative jobs working for law firms that represent investment banks, working for law firms seeking expert witnesses to defend investment banks, or working for investment banks needing a new general counsel. Some SEC officials often end up affiliated with a huge private equity fund or start a fund of their own with fundraising help from investment banks. I am sure there are many rationalizations for this." (emphasis in original)

  • Tavakoli was previously against regulation of hedge funds and structured investment vehicles. However, now that the Fed is bailing out hedge fund creditors and their troubled assets are flowing back onto the balance sheets of their sponsoring banks, regulation is no longer merely optional. There is currently $5 trillion in such structured assets, not all of which is troubled, but the total of which greatly weakens bank debt-to-equity ratios.

  "We have too many ineffective regulators: the OCC, Fed, OTC, FHFA, SEC, FDIC, and more. Watching the regulatory system is like watching bad doubles tennis players. No one hits the ball thinking the other guy will get it. Investment banks are not suffering from too much regulation. The global capital markets are suffering from too little competent regulation where it counts most. (emphasis in original)

  Without the discipline of the right to fail, we are dependent on government regulation - which inevitably repeatedly disappoints us - and the business cycle - which can only arrive on the scene after considerable damage has been done and can only get increasingly unstable as the government increases its stabilization efforts.

 The Middle East?

 

&

  For no apparent reason, Tavakoli added a chapter on Middle East problems, on which she shed more heat than light with a scattershot of points of varying accuracy. This is not a subject that can profitably be examined in just 15 pages in a book that is in reality on an entirely different subject.

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Copyright 2009 Dan Blatt