jims musings

The past cou­ple weeks have seen tremen­dous… excite­ment in the stock mar­ket.
Every­one is act­ing as though it is all a sur­prise, and yet we’ve known for months, even years, that prob­lems were brew­ing. Maybe, at this point, every­one is just stunned at the mag­ni­tude of it all. I sup­pose the same occurred in 1929–1930.
Heaven help us if those days come again.

I hear ‘Wall Street’ get­ting blamed a lot. Some­what less, ‘politi­cians’. Much less, ‘greedy peo­ple who wanted to buy more than they could afford.’ I believe the root cause is some­thing much more, and more var­ied than these.
For var­i­ous rea­sons, mostly polit­i­cal, we decided it was a Good Thing to loan money to peo­ple with bad credit or who couldn’t afford the loan. The ‘we’ in ques­tion is the tricky part. The ‘we’ ulti­mately starts with those that have money. For the most part, these peo­ple are those that are man­ag­ing large invest­ment accounts and Giant Pools Of Money. Their job is to make the money grow. This is done by invest­ing it.
In July 2003, then-Fed chair­man Alan Greenspan con­cluded his semi­an­nual mon­e­tary pol­icy report to con­gress by saying:

…the FOMC stands ready to main­tain a highly accom­moda­tive stance of pol­icy for as long as it takes to achieve a return to sat­is­fac­tory eco­nomic performance.

The con­text was, the Fed­eral Reserve had low­ered rates to spur eco­nomic growth, and peo­ple were won­der­ing what the Fed was likely to do in the future. Chair­man Greenspan is telling those peo­ple that rates are likely to remain low ‘for as long as it takes.“
So those peo­ple with money are left hang­ing. They need to make their money grow. The money they man­age, by the way, was around $30 Tril­lion in 2000. Safe invest­ments were needed, and needed on a vast scale.
Enter the CDO– Col­lat­er­al­ized Debt Oblig­a­tion. To see what this is and where it came from, a time­line is helpful:

1977 — the Com­mu­nity Rein­vest­ment Act (CRA) is signed into law. The CRA was a sig­nif­i­cant part of a series of laws intended to increase lend­ing to lower-income peo­ple. (The 1968 Fair Hous­ing Act, the 1974 Equal Credit Oppor­tu­nity Act and the 1975 Home Mort­gage Dis­clo­sure Act are some others.)

1989 — the Finan­cial Insti­tu­tions Reform Recov­ery and Enforce­ment Act of 1989 came about because of the sav­ings and loan cri­sis of the 1980s. It increased pub­lic over­sight of the process of issu­ing CRA rat­ings to banks. It required the agen­cies to issue CRA rat­ings pub­licly and writ­ten per­for­mance eval­u­a­tions using facts and data to sup­port the agen­cies’ con­clu­sions. It also required a four-tiered CRA exam­i­na­tion rat­ing sys­tem with per­for­mance lev­els of ‘Out­stand­ing’, ‘Sat­is­fac­tory’, ‘Needs to Improve’, or ‘Sub­stan­tial Non­com­pli­ance’.
This law greatly increased the abil­ity of advo­cacy groups, researchers, and other ana­lysts to “per­form more-sophisticated, quan­ti­ta­tive analy­ses of banks’ records,” thereby influ­enc­ing the lend­ing poli­cies of banks. Over time, com­mu­nity groups and non­profit orga­ni­za­tions estab­lished “more-formalized and more-productive part­ner­ships with banks.”

1992 — the Fed­eral Hous­ing Enter­prises Finan­cial Safety and Sound­ness Act required Fan­nie Mae and Fred­die Mac to devote a per­cent­age of their lend­ing to sup­port afford­able housing.

1994 — the Riegle-Neal Inter­state Bank­ing and Branch­ing Effi­ciency Act repealed restric­tions on inter­state banking.

1995 — var­i­ous changes were made to the CRA reg­u­la­tions to reduce paper­work and com­plaince bur­dens. One of the changes allowed the secu­ri­ti­za­tion of mort­gage debt– com­bin­ing many mort­gages together and sell­ing shares of that over­all debt (and asso­ci­ated monthly pay­ments) as low-risk secu­ri­ties. These secu­ri­ties are gen­er­ally called CDOs and had very high credit rat­ings– often AAA, or as good as gov­ern­ment bonds. They also had higher inter­est rates than gov­ern­ment bonds.

1997 — First Union Cap­i­tal Mar­kets and Bear, Stearns & Co launched the first pub­licly avail­able secu­ri­ti­za­tion of CRA loans, issu­ing $384.6 mil­lion of such secu­ri­ties. The secu­ri­ties were guar­an­teed by Fred­die Mac and had an implied “AAA” rat­ing. The offer­ing was sev­eral times over­sub­scribed, pre­dom­i­nantly by money man­agers and insur­ance com­pa­nies who were not buy­ing them for CRA credit.

1999 — the Finan­cial Ser­vices Mod­ern­iza­tion Act became law. This law allowed banks to do every­thing under one roof — invest­ment, com­mer­cial bank­ing, and insur­ance ser­vices. (The 1933 Glass-Steagall Act had made that illegal.)

Octo­ber 2000 — in order to expand the sec­ondary mar­ket for afford­able community-based mort­gages and to increase liq­uid­ity for CRA-eligible loans, Fan­nie Mae com­mit­ted to pur­chase and secu­ri­tize $2 bil­lion of loans.

Novem­ber 2000 — Fan­nie Mae announced that the Depart­ment of Hous­ing and Urban Devel­op­ment would soon require it to ded­i­cate 50% of its busi­ness to low– and moderate-income fam­i­lies.” It stated that since 1997 Fan­nie Mae had done nearly $7 bil­lion in CRA busi­ness with banks, but its goal was $20 billion.

2001 — Fan­nie Mae announced that it had acquired $10 bil­lion in CRA loans more than one and a half years ahead of sched­ule, and announced its goal to finance over $500 bil­lion in CRA busi­ness by 2010, about one third of loans antic­i­pated to be financed by Fan­nie Mae dur­ing that period.

2007 - Ben Bernanke sug­gested fur­ther increas­ing the pres­ence of Fan­nie Mae and Fred­die Mac in the afford­able hous­ing mar­ket to help banks ful­fill their CRA oblig­a­tions by pro­vid­ing them with more oppor­tu­ni­ties to secu­ri­tize CRA-related loans.

Feb­ru­ary , 2008 — the House Com­mit­tee on Finan­cial Ser­vices held a hear­ing on the Com­mu­nity Rein­vest­ment Act’s impact on the pro­vi­sion of loans, invest­ments and ser­vices to under-served com­mu­ni­ties and its effectiveness.

April, 2008 — an FDIC offi­cial told the com­mit­tee that the FDIC was explor­ing offer­ing incen­tives for banks to offer low-cost alter­na­tives to pay­day loans. Doing so would allow them favor­able con­sid­er­a­tion under their Com­mu­nity Rein­vest­ment Act respon­si­bil­i­ties. It had recently begun a two-year pilot project with an ini­tial group of 31 banks.

Wow. What’s hap­pen­ing between the lines is that in 2003, the Giant Pool Of Money des­per­ately wanted a place to put its money, just when the CDO was becom­ing a pop­u­lar invest­ment vehi­cle. The Giant Pool Of Money had found the finan­cial ver­sion of crack cocaine. By 2006 tril­lions of dol­lars had been invested into these CDOs. Worse yet, in the last cou­ple years, stan­dards for loans had been adjusted down­wards so far that almost any­one could get a loan.

Then the party ended. The default rates got so high (finally) that banks stopped buy­ing the CDOs. The train came to a crash­ing halt, and defaults on debt cas­caded higher and far­ther up the hier­ar­chy. Bear Stearns– one of the first to get into CDOs– crashed in May. Oth­ers followed.

The uncer­tainty about the debt sit­u­a­tion has caused the Giant Pool Of Money to stop lend­ing. No one is will­ing to buy the CDOs, so their value has plum­meted. Afraid of col­lapse, or some the col­lapse of oth­ers, banks are hold­ing onto their cash. Nobody wants to lend.

And if banks aren’t lend­ing, busi­nesses which need money– to build a new plant, to buy a ship­ment of iron, meet pay­roll or what-have-you– may go out of busi­ness. If credit is hard to come buy– car loans, credit of appli­ances or com­put­ers– then con­sumers won’t spend. If con­sumers don’t spend, then the econ­omy plummets.

Fear of all that is dri­ving the mar­ket down­ward. See­ing the mar­ket take a nose­dive causes peo­ple to sell– dri­ving it down fur­ther. The global econ­omy has been caught in a neg­a­tive feed­back loop. At some point, A) cooler heads will pre­vail, the gov­ern­ment loans and stim­uli pack­ages will have salu­tary effect and things will sta­bi­lize and improve some­what, or B) we’ll sink into a ter­ri­ble finan­cial morass which future gen­er­a­tions will call ‘The Greater Depres­sion’, ‘Great Depres­sion 2′ or per­haps a Hol­ly­wood title, ‘Return to the Great Depression.’

Time will tell. Mean­while, his­tory has shown that those with cooler heads, those that think ahead, usu­ally pre­vail and often come out ahead.

So, keep your wits about you.