Dick Kovacevich On TARP and the Financial Crisis

Dick Kovacevich, the retired Chairman and CEO of Wells Fargo & Company is one of the best chief executives of the hundreds I have met during my career in the capital markets, though I never covered banks.  I heard him tell the story of Norwest Bank for many years, and it was always the same message about the importance of the retail 'stores' and improving the number of relationships per customer. My savvy banking analyst colleague at Roulston and Company held him in the highest regard also, and he didn't hand out plaudits easily. Mr.Kovacevich's  pitch was a model of clarity, simplicity, and focused on a few core metrics. The ROA, with a modest degree of leverage and a portfolio of businesses including asset management, led to a superior ROE: it was beautiful and simple.

When he took on the famous "merger of equals" that was Norwest and Wells Fargo, Kovacevich really stepped on the hornets' nest, but he handled it with brass knuckles in a velvet glove.  Having seen him during a few pickup basketball games, he was unassuming and never drew attention to himself. As a board member at Fingerhut, I know that he was always prepared, engaged and focused on getting the company to do the right thing for all stakeholders; when he couldn't meet his own high standards any more, he left the board. It isn't any coincidence that WFC has been one of Berkshire Hathaway's core equity holdings for many years.  His piece in the current Cato Journal caught my attention, and whenever Dick Kovacevich talks about banking and financial services, it's compulsory listening for me.

In 2009, in the din of drums beating for more special Treasury/Fed/government rescue plans, we stood along side a relatively small minority writing about letting the capitalist mechanism of bank failure under existing mechanisms do its job, as it had done before.  This post, it turns out, is being re-read often today.

CEO Kovacevich was in Washington, D.C. for the 2006 Treasury TARP meeting.  He writes,

"I believed at that time, and I still believe today that forcing all banks to take TARP funds, even if they didn't want of need the funds, was one of the worst economic decisions in the history of the United States."

The Sins of the Few, Not of the Many

At some point, all banking crises have at their root, a crisis of confidence. TARP destroyed confidence in the banking system because the public concluded that all the TARP banks had to be in trouble, otherwise why would they have taken the government's money?   Kovacevich writes that "...isolated liquidity issues turned into a tsunami impacting all banks and industries."

Fewer than twenty financial institutions precipitated the crisis, in his opinion. Dick Kovacevich writes that "The housing crisis got as big as it did...only because of the existence of quasi-public/private entities such as Fannie and Freddie."

Meanwhile, of the twenty institutions he references, half were investment banks and half were commercial banks, roughly. Citi was a commercial bank acting more like an investment bank. Why, he asks, punish 6,000 commercial banks for the sins of a relative few?

Bear, Stearns, Merrill Lynch, Goldman Sachs, Morgan Stanley and others had liquidity crises. Their funding model where trillions in balance sheet assets were funded by short-term liabilities was toxic, just waiting for the music to stop when short-term funds couldn't be rolled over any more.

Abuse of the Term "Systemically Important."

After more than forty years in the banking business, Kovacevich writes,

"In my opinion, there was not any systemic reason to not let banks fail over this time."

Bear, Stearns which was half the size of Lehman Brothers should have been allowed to fail. Had this happened, he writes that Lehman's assets would have been sold as the BS workout would have provided market guideposts for bidders to price Lehman's assets. Under the secrecy of TARP, there was no transparency, and hence no confidence and hence the Treasury could talk about the lack of  bidders for all of Lehman, which is a red herring and disingenuous.

Regulatory Failure and Incompetence

One quarter after being forced to take TARP funds, Wells Fargo reported record earnings, the highest in the firm's 160 year history.  In less than one year, the TARP funds were paid back, along with $2.5 billion in bank interest cost of funds borrowed, and warrants required as part of the shotgun package for the unused and unwanted funds, were exercised in-the-money. 

When WFC stepped in to rescue Wachovia in the fall of 2008, it took about one week for WFC's auditors and examiners to conclude that expected losses and required litigation reserves would exceed existing reserves by more than $60 billion!  

How, the author writes, could have ongoing examinations by the Federal Reserve, Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation have failed to turn up this deficiency earlier?  

SEC oversight over the Financial Accounting Standards Board failed when it allowed FASB to impose mark-to-market requirements when markets had become frozen (i.e. failed) and unable to generate economically rational prices. All the market participants understood the market failure, but their opposition was cast politically as an aversion to regulation and financial discipline.  

The Fed's proprietary risk models overrode those used for the banks' own stress tests, and yet these models weren't shared with the member banks for comparison and testing.  The helter skelter regulatory regime required major banks to put forward profit and capital forecasts for the May-November 2009 in early 2009.  

The Fed's secret, proprietary risk models concluded that WFC's revenues would be 30% lower than WFC's own internal forecasts!  This kind of discrepancy should have set off alarm bells at the Fed, and making the models available for examination would have been the truly 'scientific' thing to do when confronted by an anomalous result like this.  Regulatory chutzpah, arrogance and incompetence fuelled by populist, anti-bank sentiments and by their highly paid outside consultants, ran high. 

Actual results for the forecast period were 2% above WFC's internal forecasts.

The Office of Thrift Supervision failed in its routine examination and regulation of Washington Mutual, Countrywide, IndyMac Bank, New Century, First Franklin, Option One, Fremont Financial and other sub-prime originators.  We have written about WAMU, Countrywide, IndyMac, and New Century in multiple posts.  Various reports by Special Masters/Examiners and others have made the egregious abuses available for anyone to see.

Things were dire at the massively mismanaged OTS, yet nobody was banned from their industry or prosecuted on the regulatory side. OTS was folded into the OCC: the regulatory apparatus wasn't held accountable or downsized, it just got swept under a rug with a new name.

A Simple Idea To Make Banks Stronger

Mr. Kovacevich notes that the total long-term debt of the bank and its bank holding company plus equity and reserves are broadly about 30% of assets, which should be more than sufficient to withstand even a black swan scenario. 

Debt holders, he rightly observes, contribute more capital and can impose more financial discipline than equity holders through either a bridge bank or through the bankruptcy mechanism.  If one felt that this cushion might not be adequate, the author says that an additional 5-10% holdback on uninsured deposits could be imposed; this proposal has been offered by many academic researchers on the banking system, such as Chicago Booth School of Business or the Columbia Business School. 

Dodd Frank Doesn't Make Our Banking System Better or Safer

25,000 pages of new law have not been translated into workable regulation even after more than four years after passage. Regulators have completed only about 52% of the 398 proposed new rules under Dodd Frank, according to the law firm of Davis, Polk. 

More than 100 highly trained and paid regulators office at, or work full time on the specific accounts of the largest banks on a routine basis.  

Fannie and Freddie are still around, not being wound down.  They have once again received the charter, just before the election cycles, to turn on the spigots and make home ownership accessible to all.  Have we learned anything?  No, but that's not the point in politics. 

I'll be posting on a fascinating book by Charles Calomiris (Columbia Business School) and Stephen Haber (Hoover Institution at Stanford University), "Fragile by Design."  It is a must read for any students of money, banking, financial economics and regulation.  

The Chrysler UAW Bailout

The auto industry bailouts during the financial crisis completely overturned our traditional legal statutes governing how creditors are treated during bankruptcies. With today's announcement that Fiat is buying out the 41.5% of Chrysler which it does not already own, these issues are as evident as ever.

A 2012 Backgrounder from the Heritage Foundation gives good information and references which are very consistent with the most recent October 2013 report from the SIGTARP Inspector General.

Chrysler has been mismanaged for many decades, and it has had several turnarounds.  None of them ever really addressed their operational and product development mismanagement, or their labor costs which were among the highest in the American automobile market.  Pre-bankruptcy labor costs at Chrysler were $76 per hour in May 2012, higher than both GM and Ford at the time and significantly higher than costs at Honda, Toyota and Nissan.

Pre-bankruptcy, Chrysler has $6.9 billion of senior secured liabilities and $2.9 billion of junior secured liabilities, according to the figures in the report.  $5 billion was owed to unsecured trade creditors.  Chrysler owed $8 billion to the VEBA (Voluntary Employee Beneficiary Association) formed in 2007 to assume the liabilities of the employee retirement plans.

Bankruptcy allows the corporation to restructure its contracts, subject to two heretofore inviolable principles. Secured creditors stand first in line for recoveries, including the ability to seize encumbered assets if necessary.  Unsecured creditors are considered the great unwashed, and they are traditionally wiped out or in unusual circumstances get pennies on the dollar as recoveries.

Because of Chrysler's long, troubled financial history its bonds were secured debt, which wasn't typically the case.  Senior secured creditors of Chrysler who were owed $6.9 billion recovered $2 billion, or $0.29 on the dollar.  The junior secured creditors somehow recovered $0.0 on $2 billion owed.

In this kind of structure,  which is very unusual, the unsecured creditors, including the UAW/VEBA, should have expected nothing except to be wiped out. Instead, the Obama administration converted the $8 billion into a 41.5% stake in the reorganized Chrysler, along with a 9% note.  The total 2012 PV of the Chrysler bailout, which only benefited the UAW and its membership, was estimated at $9.2 billion in the report cited.

Labor agreements and labor costs are traditionally renounced and reset in bankruptcy agreements.  While labor costs were adjusted to close the nominal gap to Honda/Toyota/Nissan to around $56 per hour, Chrysler workers will still earn substantially more than the average U.S. manufacturing sector worker, with no ties to productivity or work rule flexibility.

The exercise of Federal control and intervention in financial markets and in matters like executive compensation of corporations in which it has bought a stake at gunpoint will surely be regarded as a weakening of our economic system whose virtues we trumpet so loudly.  The government's facilitating of rent seeking by its favored political constituencies, like auto unions, is also an unprecedented manipulation of the bankruptcy process in which the role of the judges and administrative apparatus have also been marginalized. "If there's money up for grabs, I might as well be the one grabbing," a client once told me. He was a greenmailer, but his motto is still relevant today.

Fed Governor Stein on Credit Market Overheating

Jeremy Stein, a member of the Board of Governors of the Federal Reserve System, made some remarks at the St. Louis Fed Research Symposium.  His talk was titled,  "Overheating in Credit Markets." 

One of the subsidiary themes in Stein's paper was hedge fund performance.  As of June 2010, the Ivy League university endowments had forty percent of combined assets in non-traditional ("alternative") investments, versus about two percent in the global investment industry portfolio.

A raw performance comparison between hedge fund indexes and the Standard and Poors 500 equity index over 59 quarters ending Q3:2010, shows hedge funds returning 9.2 percent per annum versus 7.5 percent per annum for the 500 index, with hedge funds having lower volatility and higher Sharpe ratios.

Ivy League university endowment funds, led by Harvard and Yale, pioneered large portfolio allocations to alternative investments (hedge funds, private equity, and real estate).  Dave Swensen of Yale became the public face for popularizing the use of alternative investments.

As of June 2010, Ivy endowment funds had 40 % of their combines assets allocated to alternative investments, whereas global institutional portfolios has only about 2% allocated to these investments.

According to a March 2011, Prequin survey cited by PwC, public pension plans had increased their allocations to hedge funds from 3.6% at the end of 2007 to 6.6% at the beginning of 2011.

So, what's not to like about hedge funds?  The current consensus among financial planners is that every investor needs to have exposure to alternative investments, particularly hedge funds, in their portfolio.  Morningstar even rates long/short equity funds among their mutual fund universe, although this category had a tough 2012.  Unfortunately, hedge funds are truly "black boxes," which should always be viewed with skepticism.

A 2007 paper by John Griffin (University of Texas at Austin) and Jin Xu ( Zebra Capital Management) looked at whether or not hedge fund managers were smarter equity managers than their traditional portfolio manager counterparts.  Hedge funds, they found, tended to deal in smaller, more opaque equities.  According to the multifactor APT models, small caps are an equity sector that has historically provided excess return.  Hedge fund managers also had higher turnover than mutual fund managers.  Because these smaller cap, more opaque equities often trade by appointment, this had to mean the hedge fund managers made extensive use of derivatives.  Their key finding was rather surprising.

"Decomposing returns into three components, we find that hedge funds are better than mutual funds at stock picking by only 1.32 percent per year on a value-weighted basis, and this result is insignificant on an equal-weighted basis or with price-to-sales benchmarks. Hedge funds exhibit no ability to time sectors or pick better stock styles. Surprisingly, we find no evidence of consistent differential ability between hedge funds. Overall, our study raises serious questions about the perceived superior skill of hedge fund managers."

So, why would investor agree to pay a 2/20 (2% per annum management fees; and 20% of portfolio profits) for an investment strategy which, when measured appropriately, may not add value?

According to the New York Times,

"In September 2012, the average hedge fund still charged 1.6 percent annually in management fees and collected 18.7 percent of any gains, according to data provider Preqin. Through November of that year, the average global hedge fund investor earned just 2.6 percent, according to the HFRX global index maintained by Hedge Fund Research. In 2011, investors lost nearly 9 percent. The average annual return from 2009 to 2012, supposedly recovery years following the losses of more than 20 percent in 2008, was a measly 3 percent."

Behavioral economists would say (1) investors are greedy; (2) individual investors, and even public pension funds, are forced to reach for returns in a low return environment precipitated by Fed policy; (3) investors are easily seduced by the black box, APT argument that free lunches of excess returns available to smart managers, and (4) since the fee and trading cost structures are opaque, it is nigh impossible to get an estimate of the true value added by hedge fund managers above their risk-adjusted cost of capital.

Now, in 2012 Governor Stein references papers by Jurek and Stafford who present some interesting data that seeks to decompose hedge fund outperformance.  Overall, they find that hedge funds as a category are not market neutral, which is one of the features their brokers and sales people trumpet when funds are sold to institutions.

Jurek and Stafford find that they can mimic hedge fund performance with a replicating portfolio of cash and a short position in single equity index put options.  In a recovering market uptrend, a manager could easily outperform the SandP by inexpensively replicating the index and by selling out-of-the-money put options on the index; these would expire out-of-the money and the manager would earn the option writing premia, assuring outperformance.

In both severe and mild market declines, the authors show that their replicating portfolio generates the same non-market neutral performance displayed by hedge funds over their research period.

The authors results appear in Table V in the appendix to the 2012 SSRN paper linked here.  The sample period is 1996-2010, and the gross return to hedge funds is the Hedge Fund Research Institute Composite Index plus an estimated average annual fee of 350 basis points, equating to a gross return of 13.1% per annum.  The risk-free rate is 3.14%, and the required risk premium is the mean, annualized excess return attributable to the put writing strategy, which is 9.79%.  The total hedge fund alpha in this model, accounting for a required return/cost of capital is 17 basis points.

Remember that we have progressed from the 2007 paper which showed that hedge fund managers don't have any demonstrable advantage in stock picking or market timing acumen compared to their mutual fund peers.  Yet they appeared  to outperform traditional equity or balanced fund investment strategies.  Now, when the sources of their excess return are decomposed and an attribution is made for their "cost of capital" then their alpha is essentially zero, according to the 2012 research cited by Fed Governor Stein.

So, of course, investors are now rushing like lemmings into hedge funds.

Governor Stein notes that the 2012 historic new high inflows into high yield mutual funds and new issue spread compression suggest an overheating in the high yield market. He, however, stops short of calling it a bubble, because of some historical precedents for the spread behavior.

I thought that the hedge fund material, buried in some references was at least as interesting as the discussion of high yield and leveraged loans. As opposed to financial industry economists, academia and the Fed seem to be producing the most interesting, and disinterested, research.  A reader has to dig for it, though.

Smoking E-Mails and More From Standard and Poors

Journalists from the New York Times report today that Federal prosecutors have subpoenaed 20 million pages of emails from Standard and Poors in relation to Federal investigations about the company's ratings of structured finance vehicles.  That sounds like prosecutorial over-reaching, but that's the climate of our political environment, I guess.

Just as in every Wall Street crisis, there are smoking emails, and the Times reports these two:

“Rating agencies continue to create an even bigger monster — the C.D.O. market,” one S.& P. employee wrote in an internal e-mail in December 2006. “Let’s hope we are all wealthy and retired by the time this house of card falters.”
Another S.& P. employee wrote in an instant message the next April, reproduced in the complaint: “We rate every deal. It could be structured by cows and we would rate it.”

 The original 2010 Senate hearings on the credit ratings issue feature a high level cast of characters from the rating agencies.  A student or reader who wants a laugh, or a headache, can listen to the audio.  Like most hearings on the Hill, they are not enlightening.

One expert's testimony, I found today, was enlightening and educational for me.  He is Dr. Arturo Cifuentes, a Professor of Industrial Engineering who also earned his M.B.A. in Finance at NYU's Stern School of Business.  When Dr. Cifuentes testified in 2008 and again in 2010, he was Managing Director in the Structured Finance Department of R.W. Pressprich and Company in New York.  He also writes with a sharp sense of humor.

In relation to my post from yesterday, Cifuentes told the Senate Banking Committee in 2008,

 "A study should be conducted by an independent internationally-recognized statistical consulting organization (there are well-established mathematical methods to conduct this type of analysis) to see if the ratings have been “independent.”  Take, for example, all the CDO ratings given in a specific time period by Moody’s and S&P (to the same transactions) and compare them to see if they are “statistically different” or not.  This is a much needed exercise"

The point I was making yesterday is that this exercise is the first, objective "smell test" which would show if in fact the global financial system had three independent credit rating agencies or not.  Professor John Coffee  concluded the evidence shows a "race to the bottom" as the three agencies competed for market share and for large consulting fees.  They had nothing to gain by giving appropriately lower ratings to CDO's, since this would automatically exclude them from being considered for an investment bank's business.  Issuers needed AAA ratings from two agencies in order to go forward marketing to their institutional investors, who had to be rating driven by their charters.

If was very clear, as Cifuentes points out, that once these CDO's were trading in the secondary market, buyers and sellers looked right through the published ratings and priced the paper appropriately.  He cites the example of two CDO's issued in March-April 2007, both rated (BBB/Baa).  One was trading at LIBOR +1000 and the other at LIBOR+120.  Cifuentes says this situation is "unheard of."

The much more technical paper by Cifuentes and Katsaros convincingly demonstrates a problem facing rating agency analysts and investment bank analysts.  As we said before, the performance of the CDO depends on the credit risk behavior of the underlying pool of assets.  The analyst has to determine the probability of default, for which market proxies like CDS spreads are available.  In addition, there are ratings and fundamental analyses of assets which can provide guidance.  The big problem is how to estimate the default correlation, for which there should be relatively few events from which to make an estimate.  Then, as Cifuentes points out, the default correlations proved to be time-dependent, which is not a usual model assumption.

Rating agency analysts turned to a specific model to solve their problems, the One-Factor Gaussian Copula, which allowed a modeler to use asset correlations as proxies for the unknown default correlation.  Using this model derives implied default correlation values that are tranche-dependent, something that should not happen.  Just to give the punch line from their interesting paper,

"To sum up: the one-factor Gaussian copula method is a flawed technique to
model something that does not exist -- two very good reasons to move on
and leave all this correlation/copula nonsense behind.  Future efforts should
be focused on estimating default probabilities better.  Period.  End of story."

I believe that when one thinks about the flawed model and how it propagated itself through all the rating agencies, it explains something about the behavior of the investment banks.  Their analysts and quants are, like it or not, of a much higher caliber than those of the rating agencies.  I would guess that they knew relying on the Gaussian copula was fine for generating the AAA rating the banks needed to move the paper into the market, but they also knew that a rating based on this flawed model was unjustified.  Thus, it's no surprise that investment banks like Goldman shorted CDO's in the secondary market. Just a thought.

It really is a shame that five years after these problems were clearly identified, essentially nothing has happened to hold the culprits and their enablers accountable for a crisis whose after-effects still permeate our economy and our financial system. Politicians of both parties and our regulators are squarely to blame.

Consumer Deleveraging?

The Fed has put out its 2012Q2 Quarterly Report on Household Debt and Credit. The folks at the New York Fed's Liberty Street blog have kindly teased out the data into a more readily comprehensible format.  A summary table is shown below:

The column, "First-Lien Originations Plus Normal Payoffs" is pretty clear: it represents new mortgage originations net of mortgage payoffs associated with home sales. Look at the 2006 volume of originations at $911 billion, more than double the level in 2001.  We know that 2006 originations included some of the worst performing loans driven by the last gasp originations of notorious players like Countrywide and IndyMac before the music stopped. 2006 charge-offs from consumer credit reports are a modest $41.3 billion. Consumers are furiously pulling equity out of their homes, as shown in the second column under Mortgages, $179.1 billion in equity extraction.  It's good to remember from whence we came.

In 2009, after the onset of the crisis, home sales fall out of bed and new originations are frozen, so First-Lien Originations decline 57 percent from 2008, to $194 billion. Early refis are also in this total, as I understand it.

My point relates to charge-offs. Since 2008, $1.2 trillion in first and second lien obligations have been written off due to default and foreclosure. This is the massive, predominant effect.  How much more charging off needs to be done?  One presumes that industry reserve additions over the past few years have built an adequate cushion to absorb further losses.

The Fed authors make the point that $214 billion in mortgage indebtedness was paid down in 2010 and $242 billion in 2011.  On first blush, this seems promising, but I don't think that it's worth concluding yet that the broad consumer sector is healthy enough to start spending again. The sentiment and confidence numbers suggest the opposite.

Barofsky on Principal Reduction

We wrote in July,

"TARP and HAMP, programs of the Obama White House and its Treasury Department, were abject failures which threw billions at policies that benefited precious few homeowners. First and foremost, these programs were hare-brained in their design and therefore doomed to fail from the start. We've written before about the unregulated mortgage servicing industry and it being a stone wall to any rational, large scale mortgage resolution effort. Commentators like Joe Stiglitz described the public-private partnership idea for purchasing troubled mortgage assets as "ersatz capitalism." To let TARP and HAMP go forward without a legal plan and funding to bring the mortgage servicers into line with the government's objective was simply dim witted or cynical."

Today, Reuters reports these quotes from Neil Barofsky.

By late 2009, it was becoming apparent that HAMP would never come close to its stated goals. The program was designed poorly, and Treasury refused to hold the banks accountable for the abuses to which they subjected homeowners in the program. In one meeting I attended, after Secretary Geithner was pressed about the flaws in the HAMP program, he justified Treasury’s actions by explaining that the program would “foam the runway” for the banks by extending out the foreclosure crisis over time. In other words, Treasury was far more concerned with using HAMP to soften the blow of the housing crisis for the banks – just as the FAA once recommended spreading protective foam over a landing strip to prevent a disastrous crash of a malfunctioning airplane – than with helping millions of struggling homeowners. Now, three years later, with a tightening presidential election and a Democratic base disillusioned by the government’s abandonment of its promise to help homeowners (less than 8 percent of the funds originally allocated in TARP for foreclosure relief has actually been spent), Geithner and the administration would like to present themselves as having undergone a conversion.

Let’s be very clear about what is going on here. This is not a conversion – it is a political convenience. Geithner may well be correct when he wrote in a letter to DeMarco that an effective principal reduction program would “help repair the nation’s housing market” and that the refusal to do so is not “in the best interest of the nation,” but it is his own policies that are primarily to blame for where we are today."

Come crunch time in election season, look for a politically convenient, economically bad deal to be done for mortgagee votes in another late innings bailout with more taxpayer money. 

The Mortgage Lending Problem in A Nutshell

The New York Times had a quirky story giving notoriety to long-time bank analyst Richard X. Bove.  We see him getting upset about not getting good customer service from his bank, Wells Fargo.  I think that's like expecting a Big Tofu burger from McDonalds.  No big surprise. 

The story had this innocuous sidebar:
"He (Bove)  decided to write Tuesday’s note when Wells Fargo rejected his application to refinance his mortgage, even though he had already withdrawn the application."

Think about that for a minute.  Bove started on Wall Street in 1965, and has been a bank analyst and research director at firms like Shearson and Wertheim, and now Rochdale Securities.  He can't get a refi?

All of the talk about record low mortgage rates is just that, talk.  On the refinancing side, we've probably had burnout already.  Banks are very reluctant to lend to formerly conventional customers.  Fees are being added to formerly free services, and existing fee levels are being raised.  Lower provisioning for loan losses on the existing portfolio, expense reductions, and share buybacks can help to generate decent earnings without taking risks associated with mundane tasks like lending.

Housing is said to be recovering.  There is still a very large shadow inventory of existing homes which have not yet come on to the market, but there will be very few potential buyers who can qualify to absorb them given the disincentive for banks to change their underwriting stance.


This is a by-product of the distortions arising from monetary policy which has lost its rationale and focus. 

California Subprime Mortgages: A Bad Dream Won't Go Away

The state that spawned the California Gold Rush and "fool's gold," was the center of the subprime mortgage industry,  Although there was a spike in subprime mortgage issuance beginning in 2004, academic researchers have found that some of the worst mortgage products (option ARMs, 80/20 mortgages, and subprime HELOCs) and the absence of documented underwriting standards combined to account for high volumes of toxic products in 2006. 

In the second quarter of 2006, 8 of the 10 top subprime mortgage originators were located in California.  The top 10 orginators issued a staggering $110 billion of mortgages in the quarter, of which 82% came from the California issuers.  Ironically, Wells Fargo Mortgage was the biggest issuer in Q2 2006, with $27 billion, followed by New Century Financial with $14 billion in the quarter; Countrywide was number four with $11 billion in the quarter.  These data are contained in Bankruptcy Examiner Michael Missal's report, which we have cited before as required reading for any serious student of the mortgage crisis. 

New Century Financial writes in its disclosures, that the company is focused on "lending to individuals whose borrowing needs are generally not fulfilled by traditional lending institutions because they do not satisfy the credit, documentation, or other underwriting standards prescribed by conventional mortgage lenders and loan buyers." 

Separately, Professors Mian and Sufi of the University of Chicago Booth School of Business write, "Homeowners with low credit scores in areas with high house price growth from 2002-2006 have seen mortgage default rates climb from almost 4% to almost 15% from 2006-2008." 

In June of 2006, Missal cites an internal finance department email at New Century Financial stating that their weighted average loan to value ratio in the borrower portfolio (combining mortgage and home equity lines of credit) had reached 87%!  Missal notes that there were three CPA's on the Audit Committee, including the Board Chair. CFO Cathy Dodge was a CPA. New Century had built it's model on a foundation of "originate and distribute."  By 2006, loan quality had clearly been falling apart since 2004, and growing "kickbacks" of bad loans from securitized pools by investors threatened the ability to raise cash by unloading the toxic assets to investors, declaring a gain on sale and pumping up earnings.  All of the normal processes and reporting were in place, and yet neither internal audit, the audit committee, nor the external auditor raised any red flags. Everything was fine until the company was near death: then nobody knew what hit them.

Were the borrowers all innocent victims?  I hardly think so.  Most of the mortgages originated by New Century were stated income loans, in other words the borrower gave an annual income number with no verification and the company's independent broker originators did no due diligence.  In addition, this kind of market with this kind of lending attracts the professional fraudsters, who plague credit card companies, rent-to-own companies and direct marketers like Fingerhut. It is a Faustian bargain, because why should the homeowner turn down free money, and why should brokers turn down cash commissions, and why should the management turn down bonuses for reported EPS which is economically fraudulent? 

Professors Mian, Sufi and Trebbi produced a startling and original scholarly research paper in 2009, "The Political Economy of the Mortgage Crisis."    The 2008 "American Homeowner Relief and Foreclosure Prevention Act" passed under President Bush had a "Hope for Homeowners" program which gave strapped mortgagees access to $300 billion in federal agency insurance.  The authors show that while defaults rose in both Democratic and Republican districts, support for the Act by Democrats were "near unanimous" whatever the default rates were in their districts, where Republicans tended to vote in favor where they represented high default rate districts. Mortgage defaults draw lots of bipartisan legislative sympathy, as opposed to credit card debt or student loans, at least historically.  There are a number of interesting trends in their data which are would take too long to discuss in a post.

Expect the full court press to stay on the Mortgage Resolution Partners California bailout plan for the bad actor homeowners in California.  If the executives at the subprime lenders got a free ride, why not them?  And now we have the massively incompetent (or worse)  managers of San Bernardino adding their two cents,

"We are intrigued," said Gregory Devereaux, chief executive of San Bernardino County, which is east of Los Angeles and has one of the highest unemployment rates in the state. "Our economy in this county can't be turned around until a large proportion of the mortgage crisis has been addressed."

No, Greg, the municapal finance crisis can't be turned around until San Bernardino gets control over its employee salaries and benefits and scales services at a level consistent with an economically sensitive tax base.

Be afraid, as this giveaway is not going away. 

Government Overreaching on Seizing Mortgages

The wicked never rest, and there is no rest for beleaguered citizens who are not fortunate enough to be chosen for government largesse.  The Wall Street Journal story about California cities contemplating an absurd, Kafkaesque use of eminent domain powers is truly "appalling," as described by Scott Simon, Managing Director at PIMCO.

Mortgages are private contracts between a homeowner/borrower and a financial institution/lender.  Eminent domain is typically used, for example, when a new public highway project requires a right of way which is now occupied by homes and private businesses.  The government entity's powers of eminent domain are exercised in order to construct a project which is in the interest of a larger population, including outsiders.  In exchange for exercising this right, the government entity must demonstrate need and come to some market driven settlement with the existing property owners exchanging value for giving up their homes and business locations, plus some value for the inconvenience and costs of moving.  All of this is subject to negotiation, in theory.

As it is, eminent domain powers are often abused and applied arbitrarily to property owners who don't necessarily want to play ball at the proposed settlement rates.  We have some egregious examples here in the Minnesota Nice Midwest.  The California proposal brings abuse of government power and eminent domain to  levels that should be laughed out of town or struck down in courts.  

Cities in the California case would seize individual underwater mortgage loans. After seizing the loan, via the eminent domain subterfuge, a City would use Mortgage Resolution Partners to pay a reduced amount to the lending institution.  Mortgage Resolution Partners CEO Graham Williams comes from a background of lending to low income borrowers through a program called "Neighborhood Advantage" and from subprime lender ITT Financial Services and later at Bank of America.  The smell testalyzer is flashing red already.  Mortgage Resolution Partners would then put the formerly underwater homeowner into a new, low interest mortgage insured by the FHA with equity requirements as low as 2.25% according to the Journal.  So, of course, taxpayers are again handing out a subsidy and taking risk.  In these transactions is a nice, upfront profit for the wizards who came up with the scheme.

Professors Mian and Sufi of Chicago Booth Business School did an original and well known analysis on the explosion of mortgage lending from 2002-2006 covering a sample of 238 U.S. counties. The top decile counties for the growth in household debt to income are in California and Florida.  The single largest growth in debt ratios occurred in Monterrey County, California.  The California counties had the frothiest growth in real estate values, and we know from companies like Countrywide and IndyMac, that these Zip codes were precisely the targets for aggressive mortgage origination.  Professor John Coffee of Columbia has testified about these abuses before Congress.  Now, all taxpayers will be asked to fund a bailout for these homeowners.  Why not for homeowners in the Midwest or in Westchester County or in Appalachia?

Did I mention that Roger Altman of Evercore Partners, one of the investment banks backing Mortgage Resolution Partners, served in the Clinton Administration and is raising funds for President Obama's re-election efforts?  I have to leave the room now because the smell test is over and the stench is too much.

Fixing the LIBOR

I remember one of the first references to LIBOR in a money and banking textbook describes a quaint process in London where market makers got together before the open to"fix the LIBOR."  The British use of the word "fix" wasn't meant to be nefarious, but the news of Barclay's settlement tells us that "fixing" refers to the same fixing that happens in Italian professional soccer games.

I read on one blog that the benefit to the brokers from some of the rate manipulations amounts to an estimated £46 billion.  In the case of insider trading scandals, the illegal profits are clawed back, along with fines on top of these amounts.  In the case of Barclay's the total fine amounts to a relatively paltry £163 million pounds.  Nobody from Barclays does any jail time. 

The rigging of the rate setting process was so widely known in the company that emails fly around routinely about rates being set at a level which "kills" some profit centers, or alternatively at a rate setting that generates a  "thanks for the favor."  Clearly a bad tone at the top if everyone knew about the rigging and carried it out routinely. 

Lord Turner has talked about the so called "financial innovation" process as producing products which only serve to enrich the City/Wall Street.  There can be no social benefit to "dark pools," another financial innovation.  Mark Cuban's describption of high frequency traders as the "ultimate hackers" is perfectly apt.  Another innovation that society doesn't need.  If we value transparency and a level information field as critical to our capital markets, there is no rational argument for supporting the long list of current abuses, none of which have been substantively curtailed as a result of Dodd Frank or other regulatory frameworks.

Foreclosures in New York

Bill McBride who blogs at Calculated Risk commented on CoreLogic's 63,000 completed foreclosures in May, flat with April and below the year ago level, with a degree of optimism.  Like an iceberg, most of the inventory is below the surface, I suspect.  Here in lower Westchester County, New York walking around my old neighborhood, there are many homes at various stages of descending into foreclosure.  A flagship Mediterranean home in the neighborhood lay vacant for four years after the owner lost it.  It was recently purchased by new owners, not investors.  Most of the sales here are distressed, and the neighborhood is filled with homes not yet in the formal process.  The inefficiency and incompetence of municipal governments further impedes a resolution process.

As I've said many times before, banks never thought that they would be in the business of foreclosing, especially on such a large scale.  Banks can barely deliver core checking and savings accounts efficiently, and they certainly are not humane or efficient about foreclosures.  The mortgage servicers as a whole are a fly-by-night group and they weren't built for this either.

CoreLogic does note that foreclosure inventories are still rising in states like New York and Connecticut.  Believe it.

Taxpayers Don't Know The Promises They've Made

Just when I thought I understood something about the world of municipal finance, here comes a story from the New York Times about taxpayers being on the hook for promises made on their behalf, without their consent, by municipal bond issuers!  Here's an excerpt:

"With many cities now preoccupied with other crushing costs — pension obligations, retiree health care, accumulated unpaid bills — a sudden call to honor a long-forgotten bond guarantee can be a bolt from the blue, precipitating a crisis. The obligations mostly lurk in the dark. State laws requiring voter pre-approval of bonds don’t generally apply to guarantees. Local governments typically don’t include them in their own financial statements or set aside reserves to honor them.

“These are debts that do not show up clearly, no matter how closely you look at the balance sheets,” said Carmen M. Reinhart, an economist at the Peterson Institute for International Economics who has written extensively about government debt. They “come out of the woodwork in bad times.”

In a number of communities, especially in New Jersey, Michigan and Washington State, local officials have recently scrambled to work out fiscal emergencies caused by guarantees and similar promises.." (New York Times)

In order to give the reader a respite from unrelenting municipal malfeasance, I want to make a musical link to the theme of promises.  Below is a YouTube video of Eric Clapton playing "Promises." (nice slide guitar playing)

(At the 0:16 mark, you'll see a shot of John McVie and Eric from a session for "John Mayall and The Blues Breakers Featuring Eric Clapton," a great album I have on British Decca vinyl.  Fantastic)



Uptick In Student Loan Delinquencies

The Wall Street Journal featured this NY Fed chart showing an uptick in student loan delinquencies.  There has been much written about millions of homeowners with negative equity "strategically" going delinquent if there were a whiff of an election year bailout.  This strategic delinquency phenomenon hasn't occurred, although economists have written that it is economically rational. 

I'd offer the theory that students might be different.  Students, particularly college students, were said to be a big factor in the last Presidential election, both in terms of organizing, turning out and voting. Students are a pragmatic group, with little ethical baggage and no stakes in preserving a credit rating.  They also have a strong sense of entitlement.  My tuition's too high.  Too much homework. My grades are too low because my professors are lousy.  The dorm food's awful.  It's not my fault!( remember John Belushi's lament in the "Blues Brothers"?)

If the President were to give college students a pour boire from the Federal trough before the election in some form of loan forgiveness it would probably depend on balances and being in delinquency.  Why not get your name on the list now?  Behavioral economists--what do you think?

How Could A Credit Card Binge Be A Good Thing?

This is from a WSJ Real Time Economics Blog:

"Talk about March Madness: consumers went on a borrowing spree, adding $21.4 billion in borrowing for the month.

The surge was the largest–in both dollar and percentage terms–since November 2001. What was unusual was an increase of $5.2 billion in revolving debt. The category–which includes credit cards–had been on a downtrend over the last three years. That lack of credit use had limited consumer spending."

I don't see how this is a good thing.  The people with strong credit ratings and FICO scores continue to use their point cards, but pay off the balances.  Card issuers have purged weaker credits from their files, as well as lowering their  limits, increasing fees and margins, and tightening up grace periods for the average consumer, meaning everyone but lawyers, venture capitalists, politicians, and hedge fund managers.  If the average consumer is using this unsecured credit to ramp up spending, which may very well be likely, it won't turn out to be a "good thing."  It could be that consumers are buying Vespas.

Washington Irving on The Financial Meltdown

Thanks to Richard Fisher, President of the Dallas Fed for pointing me to Washington Irving's poetic and extremely insightful drawing of the psychological forces that lead us into financial bubbles and busts :

"Every now and then the world is visited by one of those delusive seasons, when the 'credit system' expands to full luxuriance: everyone trusts everybody; a bad debt is a thing unheard of; the broad way is certain and plain and open; and men...dash forth boldly from the facility of borrowing.

Promissory notes, interchanged between scheming individuals, are liberally discounted in the banks....Everyone talks in [huge amounts]; nothing is heard but gigantic operations in trade; great purchases and sales of real property, and immense sums [are] made at every transfer. All, to be sure, as yet exists in promise; but the believer in promises calculates the aggregate as solid capital...

Speculative and dreaming...men...relate their dreams and projects to the ignorant and credulous, dazzle them with golden visions and set them maddening after shadows.  The example of one stimulates another; speculation rises on speculation; bubble rises on bubble...

Speculation casts contempt on all the sober realities...It renders [the financier] a magician, and the [stock] exchange a region of enchantment...No 'operation' is thought worthy of attention that does not double or treble the investment.

No business is worth following that does not promise an immediate fortune...Could this delusion always last, life....would indeed be a golden dream; but the [delusion] is short as it is brilliant."


From: "The Crayon Papers," by Washington Irving about the Mississippi Bubble fiasco of 1719.

No economist could ever say it better!

Economic Expansion and Access To Credit

There's always a suggestion that banks' reluctance to lend has been a factor in lackluster GDP growth.  Domestically, leading middle market lenders like Wells Fargo have said that their better tier clients are flush with cash and don't need access to credit.  The issues for bank customers are risk aversion and a lack of confidence.  Wells Fargo said that middle market commercial lenders would generally like to grow their asset bases.

Now comes an interesting study of export behavior in Peru, based on an analysis of real-world customs data from that country.  Professors Paravasini, Rappoport, and Wolfenzon of the Columbia Business School write:
"Out of the total decline in exports from Peru, only 15 percent was driven by credit shortages. The other 85 percent was due to a drop in consumer demand. “Our 15 percent figure is a lower bound as it refers only to the decline in exports due to lack of finance to exporters. Finance can have a bigger impact as it surely also affects importers at the other end,” Wolfenzon says.


While trade is clearly based on supply and demand, it’s important to understand the relative importance of these both forces. To this end, Wolfenzon suggests a general takeaway. “The Peruvian government could not have done much to improve the country’s export performance,” he says. “The problem was a lack of demand from importing countries.”

Weak demand from developed countries in the United States and Europe is and will continue to be the issue for the resuscitation of the global economy.  On the domestic side, whether for the production of goods for domestic consumption or for exportables, the issue continues to be weak demand and a lack of business confidence.  Lack of access to credit doesn't seem to be the big issue.

Credit Getting Easier?

A recent newspaper article trumpeted a great leasing deal on a 2010 Honda Accord for $199 a month for 36 months, with 12,000 miles per year allowance.  In one sense, it could be an opportunistic grab for potential customers of a Toyota Camry, and so it's to be expected.  One of the disappointing features is that it's for a 4 cylinder, stripped model that seems like it should be in a rental fleet, but even that's okay.  The kicker was that the article said Honda's finance arm was looking at FICO scores of 710 or above for customers interested in the deal.  This is a pretty strong credit score.  It was not so long ago that this kind of deal would be aimed at a FICO score of 650 or better. 

Someone with the credit score, and by extension that income would hardly seem interested in a stripped down model.  They could probably do a better deal with a bank or their credit union at work, though that's an assumption on my part.  I don't think that this kind of deal signals any kind of credit easing in consumer lending, in fact it suggests continuing fear and trepidation.  Even as a marketing ploy, this deal seems to have little prospect of driving sales.