Bailout I: How Did We Get Here?

The Irvine Housing Blog, a website tracking the real estate crash in Irvine, California, offers an intriguing explanation for what caused the meltdown. This posting is my spin on what they've written.

The Irvine blogger points his finger at the transformation of housing finance from a business of transactions between banks and their local customers into an industry involving a series of faceless entities and the international bond market. The Fed's monetary ease after the 9/11 attacks was merely the spark that fell onto a dry, tinder-strewn forest floor.

To understand what happened, we have to take a look at the mortgage banking system and how it changed over the past 30 years. Prior to 1980, most people got their mortgages from a savings and loan association, also known as a "thrift." These local institutions gathered deposits at a regulated rate, and lent the money out at a higher rate. The difference, or the spread, paid for costs, profits, and the occasional default. No one ever called it exciting, but the livin' was easy. "Take it in at 3%, lend it out at 6%, be on the golf course by 3 o'clock." As an icon of the easy-livin' 1960s, the so-called 3-6-3 rule was right up there with Dean Martin, the '66 Mustang, and the three-martini lunch.

The end of the good old days

Then it all changed. In 1971, the U.S. abandoned the gold standard and allowed the dollar to "float" against other currencies. Money could now flow freely around the world, seeking the highest rates of return. In the background, inflation was heating up. And then then it really took off after 1974, when the Arabs cut off the flow of oil and quintupled the price. That, along with the floating of the dollar, drove a silver stake through the heart of the banking system as we once knew it.

By the mid-'70s, ordinary people started abandoning banks and thrifts for other investments that paid more. Why stick your money into East Nowhere Savings & Loan at 3% when you could buy a Treasury bill for 5%? Worse yet, East Nowhere's great assets -- those solid home mortgages written in the '50s and '60s that hardly ever defaulted -- were now a lead weight around its neck. Somewhere between the second and the third martini, it dawned on East Nowhere's bankers that if their mortgages were paying 6% while they had to offer 6.5% to keep deposits, there'd be no more Cadillacs and no more country clubs.

Regulators and politicians were also behind the 8-ball. If you told East Nowhere S&L that it couldn't pay more than 3% on savings when any common fool could get 5% somewhere else, it would run out of money to lend. Then construction would stop, and the economy would go into the tank. If you allowed East Nowhere to pay whatever they wanted for deposits, there was still the matter of all those old mortgages on the books that weren't yielding enough to pay the S&L's light bill, let alone the president's club dues.

Facing death, the S&Ls reach out to Wall Street

It didn't take long for bankers to switch to iced tea for lunch and brush up on Finance 101, namely the need to pay close attention to the duration of your assets relative to the duration of your liabilities. If the average mortgage lasts for seven years but your average savings deposit sits for six months, and all the regulations keeping things stable have been blown away, you've got a big alligator swimming in your pool just waiting for the right moment to strike.

Some of the S&Ls crossed over to the dark side and made stupid, risky loans in their search for better returns. Remember the commercial real estate bubble of the 1980s and the S&L bailout of the early 1990s? Other S&Ls took the high road and hopped on a bandwagon called "securitization." Oh, they'd still make loans just as they always did. But instead of holding them, they'd turn them into bonds and sell the bonds.

Voila! Duration matching could be someone else's problem. The customer would keep sending mortgage payments to East Nowhere Savings & Loan, blissfully unaware that the money was being passed through to the holders of bonds based on his and other mortgages. East Nowhere would be the"originator" of the loan, taking a fee for finding the borrower, checking his references, and handling the paperwork. It would also be the "servicer" of the loan, taking another fee for collecting the payments and managing the escrow accounts, along with the occasional foreclosure.

But someone else would be the "holder" of the loan. That someone else could be anyone from an insurance company in Portland, Oregon to a Saudi prince looking for a place to park his petrodollars. There was no need for the lender to know the borrower. The bond indenture would suffice, thank you.

That, in essence is what happened to mortgages after 1980. A couple more wrinkles that matter: It's not East Nowhere S&L that actually issues the mortgage bonds I just mentioned. Instead, East Nowhere sells its mortgages to Fannie Mae or Freddie Mac, two gigantic corporations created by the federal government to turn mortgages into bonds. Freddie and Fannie create the bonds. Oh, and East Nowhere competes for originations and servicing rights with "mortgage banks" like Countrywide Financial and Ditech.com (owned by General Motors, which cut its teeth by having financed car loans). Maybe you've noticed that just about all of the S&Ls have gone away? They've been outgunned by the big boys.

Mortgage bonds: Theory vs. practice

From essentially 0% of the market in 1980, the "securitized" share of mortgages has grown to about two-thirds of the pool today. On the surface, it's a great idea. Holding mortgages is a financial activity. Originating mortgages is a sales activity. Servicing mortgages is a matter of computers and data processing. Capitalism is all about specialization, and it only stands to reason that a salesman left to sell is going to be a better salesman than one who also has to worry about duration mismatch and escrow accounts. Everybody's happy! Why, it's a classic win-win-win-win solution!

Yeah, right. The more wins, the more losses. They never tell you about the risks until it's too late.

What's missing from this picture? Checks and balances. In days gone by, the East Nowhere S&Ls of the world had good reason to lend carefully. If you hold onto a 6% mortgage and the borrower defaults, you'll lose at least two or three good loans' worth of profits by the time it's all over. Not to mention being the evil banker who took some poor guy's house away. Your shareholders won't like it very much, and neither will the regulators. And you know what? In days gone by, some of the S&L bankers actually lost sleep over debtors who fell behind. Don't tell anyone, but some of them had a heart.

But what if a payment stream stops going into a mortgage bond? Phone calls get made and wheels turn. But it's not the same. The guy who wrote the loan has long since been paid. The servicer makes even more money off the foreclosure. The poor busted debtor gets evicted by some corporation with nothing but letters in its name and a calculator in its chest. As for whoever got left holding the bag for those bonds, well, what's risk all about, right?

On Main Street they call this "irresponsibility." On Wall Street, the financial geeks call it "moral hazard." I call it "magical thinking" or "not giving a shit." Call it what you will, but in today's securitized mortgage business this mentality is everywhere you look.

Naturally, everyone will tell you they're honest. What are personal delusions and corporate P.R. departments for, anyway? Borrowers will haul out the usual excuses, some of them good and most of them embarrassing. The originators will claim to have followed the rules, checked the references, and so on. The securitizers will tell you they've got their eye out for fraud. The bond buyers? Ah, the bond buyers. They're my favorite, because if anyone should have known better, and in fact did know better, they're the ones.

The bond buyers will sing a song of prudence, advising you to look at historical data showing miniscule mortgage default rates. Catch one of them on their second after-dinner drink (the three-martini lunch being a relic of more carefree days), and they'll tell you something else: Fannie and Freddy are too big to fail. The bond buyers could afford to ignore credit quality. By and large, they work for big pension funds, mutual funds, and insurance companies. Their job was to pretend that the mortgage bonds were solid. Given that Uncle Sucker is there to bail them out, were they wrong?

There's no welfare queen like a corporate welfare queen

In other words, if the shit really hits the fan, the federal government will rescue the bondholders. The alternative is to see the whole financial structure collapse, and trust me, no one wants that. We have no choice; they've got us over a barrel. We bail them out, or there's a second depression. Really. The Federal Reserve refers to this as the "implicit government guarantee" on Freddy and Fannie's securitized mortgage bonds. All $5+ trillion worth, no matter how crappy the collateral. You see, the securitization business might be efficient, but it's more efficient in more ways than one. It is a remarkably efficient buck-passing mechanism, and it's a remarkable efficient vehicle for fraudulent dealing.

The bottom line is this: The bag holder is the same dude who got stuck with the bill for the S&L "crisis" of the 1980s. He is Uncle Sucker. And don't kid yourselves, every penny that Uncle Sucker pays out comes from you and me. No matter how careful we were with our money. That is what "moral hazard" is all about: the ability to stick it to millions of faceless suckers who you'll never meet and who'll never meet you. If you managed your personal finances in a responsible manner, you'll wake up with someone else's hangover. The people who threw the party? Worry not. They've been paid.