by Michael Doliner
(Swans - March 10, 2008) By now most people know that the "subprime" crisis is no such thing. What has happened is the final result of the long decay of the rate of profit (1) in the American economy. As productive activity no longer paid, investors turned to interest on credit to provide sufficient rates of return. During the first part of the twenty-first century they devised new ways to lend. Bankers and mortgage brokers offered credit to just about anybody who breathed, and credit built upon credit. Mortgages were only one area in which they did this, but looking at them gives a good illustration of what is happening.
The note guaranteed by a mortgage is a promise to pay a debt, usually in monthly installments. The note provides its owner with a stream of income and he can sell the note for a lump sum. Mortgage brokers have sold the notes for a long time, but recently they have done so in new ways. Wall Street got into this game by creating new debt instruments (bonds) called Collateralized Debt Obligations (CDOs) and Structured Investment Vehicles (SIVs). They are nothing more than collections or bundles of notes (backed by mortgages) that can be sold to investors. If someone can borrow money for a lower interest rate than is on the note then he can use the borrowed money to buy many notes. Thus they built a pyramid of debt. Since Japan has been lending money at practically zero interest, this pyramid grew huge.
These Wall Street bundles looked like practically foolproof sources of income. Actuaries judged the likelihood of homeowners defaulting on their mortgages from past performance and assured everybody they were safe. Given that investors were buying large bundles of loans the likelihood of default could easily be factored into the price. The likelihood of default on riskier loans could be offset with lower prices. Wall Street divided the bundles of loans up into "tranches" with the riskiest giving the largest rewards.
But to make all this even safer Wall Street brokers bought insurance through "monoline" insurance companies whose business is to insure bonds. They insured buyers of bonds against default. These monoline insurance companies had, before this, insured primarily municipal bonds. These rarely default and the monolines had a sweet deal. But this new source of business seemed even sweeter. Because their business had been so solid up until this time these monoline companies all had Aaa ratings with Moody's, Standard & Poor's, and Fitch, the world's three ratings agencies. Their ratings transferred to the bonds they insured, making the mortgage-backed bonds Aaa investments even though many of the borrowers were "subprime." With all this insurance, investors, including staid conservative banks, gobbled up these investment vehicles.
The game seemed so good that the most sophisticated investors, including banks such as Citibank and J.P. Morgan, and brokerage firms such as Bear Sterns, invested in these vehicles and encouraged their clients to do likewise. Many Hedge Funds joined them. Foreign countries jumped in. The final owners of the notes were very far away from those who originated them. Local mortgage brokers wrote the mortgages but then quickly sold them. These "account executives," who were supposed to check on the borrowers' ability and inclination to pay, had no incentive to be too careful, and were soon fired if they were. Mortgage brokers made money on the number of mortgages written, not on their quality. They were not hurt when the borrower defaulted.
All this led to an enormous increase in the amount of mortgage money available and a loosening of the standards for loans. Since mortgage brokers didn't care, people were given mortgages they couldn't possibly pay. People out of work refinanced their houses, increasing their debt but remaining afloat on the proceeds. Thus there were more buyers with more money looking to buy houses, and the prices of houses skyrocketed.
With all these questionable loans on ever inflating property values, eventually the defaults began to dribble in. And soon there were enough of them to make the owners of the CDOs and SIVs nervous. People who had money in hedge funds heavily invested in these vehicles wanted to take their money out. But when the hedge funds tried to sell the CDOs and SIVs to pay off the investors they found there was a very weak market for them. Word of the defaults had gotten around. Since these hedge funds had borrowed most of the money to buy these securities, they had to sell a lot of them to get much capital back. In July 2007, two Bear Sterns hedge funds collapsed. (2) Share prices for other funds fell off a cliff. The market for CDOs and SIVs suddenly ended. Nobody wanted to buy them, period.
The sudden end of the market for mortgage-backed bonds turned off the gusher of money that Wall Street had been pouring into mortgages. Banks now had to look at mortgages as if they were taking the risks themselves, and they became a lot more careful. In the heyday they had offered no money down mortgages and even lent more than the value of the property, allowing the new owner to emerge from the deal with money in his pocket. They had given money to people with dubious credit histories and insufficient income. No more. With more stringent guidelines and demands for larger down payments the buyer pool shrank and buyers could buy less house. A housing market geared to a large demand suddenly found it had a smaller one. Mega-builders in Florida, California, and elsewhere found that houses in their giant projects were not selling, and they stopped building. The booming real estate market ended, and prices began to fall.
With falling prices mortgage defaults increased. Those who had been refinancing their houses to pay the mortgages were stuck. Speculators who had bought houses expecting to flip them at higher prices were also stuck and wanted out fast. Adjustable rate mortgages that had been sold with ridiculously low "teaser rates" began to reset to much higher rates that the borrowers couldn't pay. They defaulted. The snowball of real estate decline began to roll.
As defaults increased, the CDOs and SIVs that banks, brokerage houses, and other clever investors still owned became less and less attractive. But these securities retained their Aaa ratings because the monoline insurance companies backed them, and the monolines had Aaa ratings. When people began looking at the monolines it became obvious that they were woefully undercapitalized. Their exposure to the mortgage backed securities was something like one trillion dollars, of which about $130 billion had gone bad, (3) and their capital amounted to about $15 billion. Clearly, they should already be out of business. At least they should lose their Aaa rating. But if they lost their Aaa rating then the bonds they insure would also lose their Aaa rating. If that happened those bonds would no longer be investment grade and the banks, because of banking regulations, would have to sell them. But there is no market for these things now. The banks would have to take huge losses, probably going bankrupt. These liabilities seem to be as large as the entire American banking system. So even though the monolines were insurance companies nobody wanted them to actually pay off on their policies, for that would put them out of business. Their Aaa ratings were worth more than their cash.
But it didn't take an Einstein to see that the monolines were essentially insolvent. The ratings agencies, Moody's, Standard & Poor's, and Fitch, threatened to downgrade their ratings as a result. To avoid this, a number of "bailout plans" were floated, consisting, essentially, of banks lending money to the monolines. The ratings agencies, aware that a downgrade of the monoline ratings might bring down the whole system, reaffirmed the Aaa ratings of the monolines, even though none of these bailouts could possibly cover the real liabilities, and none of them has materialized in any case. For anyone who would lend money to the monolines, essentially bankrupt businesses, would have to be crazy.
When the ratings agencies reaffirmed the monolines' bogus Aaa ratings they completely discredited themselves, essentially putting themselves out of business. The ratings were so obviously fraudulent that nobody will believe them again. However, a whole new paradigm developed in which fraudulent ratings may not matter. Even though nobody believes in the monolines' Aaa ratings they serve their purpose anyway. For the banking regulations specify Aaa ratings for investment backed securities and say nothing about the plausibility of these ratings. The mortgage backed securities will retain their "investment grade" rating as long as the monolines retain their Aaa ratings, no matter how obviously bogus. The stock market has caught onto the game. When news of a bailout appeared the market rallied, even though these clever traders could not have helped knowing that the bailout would never happen and was, in any case, insufficient. They knew the drama was a farce. They simply agreed en mass to play along. The alternative was a collapse of the whole system.
The American economy now depends upon all the players going along with good news they all know is bogus. Nobody wants the entire system to fail, so they play along with the game. Although the mortgage backed securities are nearly worthless, nobody wants to find out just how worthless they are. So nobody puts them on the market and nobody tries to collect on the monoline insurance. To shore up the monolines' bogus Aaa rating the banks float news of bogus bailout plans no one is likely to put into practice unless he is a complete idiot. The ratings agencies take these obviously bogus bailout plans at face value, ignore the fact that even if they were to be implemented they would be woefully inadequate, and reaffirm the monolines' bogus Aaa ratings. So everyone pretends that these mortgage-backed securities, sometimes inadvertently called toxic sludge, are still valuable. Stockbrokers go along with the game by pretending these bailout plans are really good news even though they know they are bogus, and they bid up stocks. As long as this continues the banks and brokerage houses can keep these securities off their balance sheets and in hedge funds. Since everyone's exposure is hidden nobody knows who is holding these worthless securities and is thus essentially broke, so nobody wants to lend any money to anybody.
So much for credit as a source of profit. The whole credit system is frozen up. It is like someone holding his breath. How long can he go on? Who knows, but not long. At the bottom of the whole pile the lowly mortgage payer is still having his problems. Defaults and foreclosures are increasing dramatically, and housing prices are declining. The credit freeze is accelerating the decline. This has produced something new. Many homeowners are discovering that their houses are worth far less than they owe on them. "Not since the Depression has a larger share of Americans owed more on their homes than they are worth. With the collapse of the housing boom, nearly 8.8 million homeowners, or 10.3 percent of the total, are underwater. That is more than double the percentage just a year ago, according to a new estimate of the damage by Moody's Economy.com." (4) Thus even though they might be able to pay the mortgage, they find no real inclination to do so. Whereas people used to feel morally obligated to pay debts they had contracted for, they no longer do. A new Web site shows them how to walk away without any liability. (5) As these people walk away, prices will fall still further. The idea that paying one's debts is essential to an upright and honorable life seems no longer current. The old threat of damage to one's credit rating no longer seems so scary. Homeownership, now that prices are falling, no longer seems so attractive. Renting is looking good. The whole idea of homeownership as a source of security seems to have vanished. Credit card defaults and car loan defaults are rising almost as fast as mortgage defaults. To repay or not to repay is now seen as a purely business, rather than a moral, decision. This pulls out the supports from all the mathematical models upon which the system is based.
The really fun news is that this is only the tip of the iceberg. "Credit default swaps" can be thought of as freelance monoline insurance on any kind of debt obligation. But unlike with monoline insurance, nobody knows who is obligated to pay or whether he is able to do so. It is estimated that there are about $43 trillion in credit default swaps. (6)
With frozen credit markets, capitalism has come to an end. Making things doesn't pay, and now you can't lend money to make money. What is a capitalist -- excuse me, entrepreneur, going to do? Naturally he will look to the Fed for a rescue. Free markets are fine and dandy unless I need a bailout. The Fed has the right to print money and lend it to banks. Great business if you can get it. The Fed, to unclog the arteries of the credit system, lowers its interest rate. But to whom are you going to lend money? Nobody knows which banks are already bankrupt, and now even the little guy is no longer finding his obligation to pay all that much of an obligation. In the end the whole credit system depends upon the social convention that debts ought to be repaid, and this social convention seems to be dissolving. When people begin walking away, lower interest rates are not going to help.
Meanwhile everybody is edging towards the exits. Every investor would like to get out without anyone else noticing that he has left. Once it becomes obvious that everyone wants out the rush to the exits will keep everyone from leaving. But don't worry. I'm sure the Bush administration has a plan.
1. "United States economy at the turn of the century: Entering a new era of prosperity?," by Fred Moseley, The Capital & Class, Spring 1999.
3. "Monoline Insurance: There's a New Sheriff in Town...," by Barry Ritholtz, seekingalpha.com, January 29, 2008.
6. "Investment Outlook: Pyramids Crumbling," by Bill Gross, PIMCO ("one of the largest specialty fixed income managers in the world"), January 2008.
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