classical economics
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and policy design

Cutting Sub-Prime Down
By Wayne Jett
© November 17, 2008

    Throughout 2007 and most of 2008, Americans were told defaults on sub-prime mortgage loans secured by residential housing loomed as a crisis capable of collapsing the national and international financial systems. These warnings came while some governmental and Federal Reserve officials expressed confidence the sub-prime problem could be “contained” before it affected broader financial structure and economic growth. Now that 2008 has produced a dozen failures of major financial firms and the epidemic is spreading into industrial companies, those who warned about sub-prime loans appear vindicated.
    Or are they? Something about the sub-prime loan calamity never rang true. The fact is sub-prime mortgages – those loans made to owners of housing who do not have credit standing, earning power or equity that meets ordinary standards for home loans – cover a relatively small portion of all U. S. housing. Even then, only a portion of all sub-prime loans will default. Those that do are secured by houses with significant value.
    So, how can it be that losses on defaulted loans, net of house value and mortgage insurance, are so big they wreck national and global economies? Quite simply, it cannot be and it is not so.
Making Sub-prime Mortgage Defaults
    The financial debacle still engulfing financial markets and economies and the world is not solely the doing of mortgage brokers, home builders or homebuyers with sub-prime credit. Each did play a role in creating bumper crops of sub-prime mortgages in 2006 and 2007 which are defaulting at higher than normal rates.
    The Federal Reserve, too, played a central role in producing these defaulting mortgages. The Fed raised interest charged (through banks) to small businesses above market rates, effectively cutting off credit and intentionally causing layoffs of employees (many of whom are sub-prime borrowers). In 2006, the U. S. still added 800,000-plus payroll employees, but the Fed’s ill-advised policy cut about 40,000 jobs monthly as 2007 began. By November, 2008, weekly new unemployment claims jumped above 500,000, which should be charged in large part to the Federal Reserve.
    The Federal Reserve chose to put sub-prime borrowers out of work. The Fed policy charade equates “fighting inflation” to reducing consumption by jobless people so prices for goods and services will be lower. All the while, it purposely creates real inflation by devaluing the dollar with too much liquidity. Were Fed policy not so destructive, many sub-prime mortgages presently delinquent would be performing.
Unraveling Sub-prime Mystery
    Even the Fed-boosted default rate on sub-prime mortgages does not produce national financial meltdown, however, so the true nature of problems affecting U. S. and global financial markets remains to be identified. Doing so brings to the fore an informative report by the highly readable Michael Lewis titled “The End” published November 11. In it, Lewis tells how hedge fund manager Steve Eisman learned a tactic to drive down the market price of bonds backed by sub-prime mortgages (“mortgage-backed-securities” or MBS). Buying a credit default swap (CDS) on a specific bond causes the market price of the bond to decline. As more CDS are bought on a specific bond, the premium cost paid for each CDS goes up, which makes the bond appear more risky. When a bond’s default risk rises, its market price falls.
    The rarely mystified Lewis gives some credence to Eisman’s story that some sub-prime MBS are rated AAA solely due to stupidity or corruption of rating agencies. That is by no means the case. The reason is a design feature of sub-prime MBS called “over-collateralization.” Assume sub-prime mortgages have an historical maximum loss rate of 12.5%. To achieve an AAA rating, a sub-prime bond may over-collateralize by loading a million dollar bond with $1.25 million principal value of sub-prime mortgage collateral. By that design, even if losses double the maximum historical rate, the owner of the MBS is paid in full with interest. That level of risk may fairly be rated AAA.
Gaming the ABX Index
    Without even mentioning the ABX index, which purports to track market value of MBS, Lewis’ report of Eisman’s investment tactics confirms what some minds already suspected. The ABX index was driven down – manipulated – in 2007 by heavy buying of CDS on specific bonds identified and tracked by ABX.
    The ABX is often misinterpreted to be a broad gauge of market prices in the very large MBS universe. But ABX is derived with reference only to market prices of a very limited number of specific MBS bonds. Four bonds in each of six tranches, or rating levels, comprise only 24 bonds. With that obviously vulnerable design, one or more hedge fund managers simply identify 24 specific bonds in the ABX, buy CDS heavily on each of those bonds and – voila! – the financial world, including independent auditors of financial firms, witnesses a crashing ABX index.
Targets of Sub-prime Game
    Within weeks after its inauguration in March, 2007, the ABX index declined sharply. The first victims of the crashing ABX were mortgage companies whose products appeared to be losing value, even though ABX did not actually connect with or measure those values or even their market prices. Mortgage companies lost buyers of their mortgages, and thus lost both capacity to fund additional loans and profitability. Their share prices were quickly wiped out, cutting off access to capital needed for survival, by short sellers who enjoyed SEC license to fail-to-deliver shares. Some Wall Street investment banks connected with ABX were prominent in cutting off lines of credit to mortgage lenders.    
    The second round of victims of the ABX “crash” were more capital intensive, highly leveraged hedge funds, banks and government sponsored entities which invested in MBS. Their auditors, too, insisted upon using ABX as the appropriate metric of market value for MBS under a new accounting standard, FASB Rule 157, which required MBS value to be “marked-to-market” quarterly. Coincidentally effective in 2007 as was ABX, Rule 157 together with ABX produced hundreds of billions of losses in value of MBS owned by financial firms. These mark-down losses were run through profit-and-loss statements quarterly, completely overwhelming operating profits.
    The combination of ABX, Rule 157, MBS and CDS produced the biggest collapse of major financial firms in U. S. history during 2008. Not even in the Great Crash of 1929 or in the Great Depression did so many financial giants fail. Nor did U. S. agencies intervene so drastically in the affairs of private markets.
Secret Within a Secret
    But the “secret within a secret” inadvertently revealed in Lewis’ “The End” is still to come. Eisman had a problem, Lewis reports. The problem was that the volume of profits to be gained in selling short the shares of homebuilders, mortgage lenders and owners of sub-prime loans was very limited. Why? The reason stated for the low profit ceiling is most revealing: “the scarcity of truly crappy subprime-mortgage bonds ….” There were too few really bad sub-prime mortgage bonds!
    This limited number of bad sub-prime mortgages, Lewis explains, was overcome by true genius of the tactic designed by Wall Street to drive down MBS prices. Buying CDS on specific bonds meant, by the manner this tactic operated, “the scarcity of truly crappy sub-prime-mortgage bonds no longer mattered.” (Emphasis added.)
    This is probably the most informative statement in the Lewis piece. First and foremost it reveals that really bad sub-prime MBS were scarce – hard to find. That in itself speaks volumes about the extent to which these financial issues have been misstated and misreported to the public. More emphatically, however, it opens the door to understanding why this “scarcity … no longer mattered.”
Bad Bonds Copy Machine
    The scarcity of bad quality sub-prime MBS no longer mattered for two reasons. First, the price of any sub-prime bond could be driven down with the CDS-buying tactic, so even “good” sub-prime bonds could be made to appear “bad.” Second, the scarcity of bad sub-prime bonds was overcome because the CDS instrument figuratively duplicates the bond instrument it insures against default. The CDS itself is in the nature of a side bet on the bond it covers. The seller of the CDS bets the bond will be repaid as promised, while the buyer of the CDS bets the bond will default. To document the bet accurately, the CDS re-creates the obligation of the underlying bond, and the CDS seller promises to pay what the bond issuer fails to pay.
    By this process, each new CDS conceptually creates another “bad” MBS bond with another party (the CDS seller) exposed to risk of loss upon default by the same “bad” borrowers. With every new “bet” through purchase of a CDS, the original amount of loss at risk doubles, and re-doubles again.
    This is how the “sub-prime problem” became so huge. The hugeness comes not at all from sub-prime mortgages, whose default problems are manageable. The huge problem is not really sub-prime mortgages, but CDS, Wall Street’s recent big idea for profiting immensely when bad things (defaults) happen.
Credit Default Swap Casinos
    If CDS is the problem, what is to be done for it? Wall Street says just organize one or more clearinghouses (aka “casinos”) to facilitate trading in CDS. That makes sense for those with winning bets in the CDS game, who want the “house” to be able to pay.
    But do CDS casinos make sense for bank depositors, insurance policyholders, shareholders or U. S. taxpayers? A bank that sells CDS exposes its depositors to risk of loss on CDS, so CDS threatens the FDIC. An insurance company that sells CDS increases the risk that its insurance policies and annuities will default, as AIG’s debacle showed. Taxpayers need no reminder that Wall Street is capable of putting them on the hook whenever big losses arise.
    But should depositors, insureds or taxpayers be made liable to pay off bets on which winning tickets are held by Wall Street or anyone else, simply because government regulators kept hands off when bets were being placed? Some CDS are bought, not as bets, but to protect or to hedge bona fide business transactions. But even those CDS do not deserve performance at the expense of depositors, insureds or taxpayers.
Fixing Credit Default Swaps
    CDS have been sold without regulation and without adequate reserves commensurate with risks. Government intervention into private matters is often objectionable, but not when inaction allows an innocent public to be victimized by opportunistic financiers. When obligations of parties to private pension plans were re-written by Congress retroactively in 1974 and 1980, legislatively imposing billions in new obligations onto employers, the U. S. Supreme Court blinked not an eye.
    Congress ought to consider doing something about credit default swaps now. Voiding CDS would cut the sub-prime mortgage loan problem down to its original size: very manageable. ~