An Incomplete Education
Many intelligent readers of Georgia Trend have been confused or upset at the dizzying array of terms used to explain the current economic crisis. Here is an incomplete education on some of the many investment schemes that have turned everyone’s 401(k) into a 201(k). They include loan affordability products, teaser loans, 80/20 loan pay options, derivatives contracts, CDOs, credit default swaps, asset-backed securities and tranches that have been affected by mark-to- market accounting rules.
Let’s use the example of someone who has started a mortgage banking company – this is a work of fiction to explain, not find blame.
Say a man named John Galt started a company called The Galt Mortgage Company in 2000, right at the beginning of the housing bubble. Unlike commercial banks, a mortgage bank is not licensed to take deposits and, unlike some banks in the mortgage industry, Galt’s would sell a homebuyer a mortgage, take a fee to pay itself administrative costs, then quickly sell the mortgage for additional fees to other banking institutions including Fannie Mae, Freddie Mac and big Wall Street investment firms such as Bear Stearns. The Galt Company would service the loan, but had the advantage of not worrying if the mortgage would be paid, because the loan was owned by someone else.
Galt’s commissioned salespeople, called loan originators or mortgage originators, at first used a common practice of asking the potential homeowner to prove his or her income and provide a 15 percent down payment on the home. Applicants were also required to provide a financial statement to show that the home loan payment would not take up more than 33 percent of their monthly income. This was the standard rule used by the industry to prove that the loan would be secured and that the homeowner could comfortably make the payments.
If the credit history checked out, Galt would make the loan, then turn around and sell it to another bank. If a customer’s credit rating was a little off, the loan would be classed a subprime, and the customer would pay a higher fee and be required to put more than 15 percent down. But subprime loans at that time were a small part of Galt’s operation.
In 2001 the Federal Reserve began cutting interest rates dramatically. This fueled a boom in homeowners refinancing their homes and taking out second mortgages to pay for items such as boats, jewelry and vacations. The boom started driving home prices higher and higher, and mortgage lending became big business. Wall Street firms became major customers, and competition among home lenders for subprime mortgages became fierce. Galt had his originators push what were called affordability products. If the loan was risky, the fees would adjust upward.
Wall Street firms such as Lehman Brothers and Morgan Stanley were hot to buy more and more subprime loans, because the fees were so profitable. Galt’s company was booming, and he was having trouble supplying enough loans to satisfy demand.
Affordability products were expanded even more, and home prices continued to rise. In 2005 Galt instituted a pay option plan, for which the borrower pays a low teaser rate, to reset at a later date. Homeowners were not required to prove they had financial ability to pay the loan; the financial statement requirement was abandoned. Customers with poor credit histories were simply charged an even higher fee.
Soon Galt started issuing loans with no down payment called 80/20 loans. Twenty percent was for the down payment (which was financed as a second mortgage); the other 80 percent was for the balance of the purchase price. Zero down payment loans became the norm for subprime lending. Wall Street loved them because of the high fees involved.
As prices rose, a major market developed in second home purchases. Customers would purchase a vacation condo for $1 million with a zero down loan, wait for six or eight months and “flip” the home to another buyer for $1.3 million. At the end of the housing boom, some 40 percent of the mortgage industry’s distressed or toxic loans consisted of these types of loans.
To further explain, let’s say one of the Galt mortgage originators sold 30 people home loans of a million dollars, called Home Equity Loans or HELs, using their homes as collateral. To achieve each million-dollar mortgage, Galt contacted an appraiser to value the homes well above what they were purchased for some years earlier.
Home prices were skyrocketing, so it was easy to get a home appraisal to match the mortgage. After all, the thinking at the time went, prices would continue to rise. The customers didn’t have to put any money down or show proof they had income to pay back the loans. The lending agent provided the homeowners an 80/20 loan with a reduced payment the homeowner could normally afford – with a carrot. The carrot was a payment that was reduced to what the homeowners could afford at the time, with the idea the loan payments would reset later.
The 30 homeowners’ loans were sold to a bank on Wall Street named Easy Business Bank and Trust. The loan assets were transferred off of Galt Mortgage Company’s books onto Easy Business’s. (Not all banks fell into this trap. Remember, this is a fictitious account.) Then the 30 mortgage loans were packaged by Easy Business into a common derivative called an asset-backed security or ABS, an instrument whose value is collateralized or backed by a specific pool of assets called collateralized debt obligations or CDOs.
The Easy Business Bank and Trust then took the ABSs, split them up and divided them into bundles called tranches (think of them as slices of a bundled loan). Some loans in the tranche were less secure, because the original mortgage payers’ credit was below grade. These were placed in the tranche with a mortgage belonging to a person with a higher credit rating. The hope was that the better rated loans would make up for any bad loans.
The Wall Street bank was betting the payments or cash flow streams, called legs, from the bundled loans would increase when the loans reset using higher interest rates at a later date. The Easy Business Bank and Trust had a credit rating agency rate its ABSs, or the $30-million worth of mortgages sold to them by Galt, as a AAA investment.
Then Easy Business hedged its bet by creating another derivative called a credit default swap or CDS. To achieve this hedge, Easy Business Bank and Trust asked another bank to exchange one revenue stream or leg of the tranche for another. Easy Business was betting the tranche it swapped or exchanged would not be as secure, and therefore it was hedging the bet by getting it off its books and passing the bad loan off to another institution.
Simply put, if the loan is suspect, Bank A strikes a deal to pay a fee to Bank B, if Bank B promises to compensate Bank A should the loan go bad. Bank A sheds some of the risk and has the loan off its books, and is free to make even more loans. Bank B assumes the risk, but enjoys a nice fee income.
This credit derivative was invented during the mid 1990s by some geniuses at J.P. Morgan-Chase. They sold the concept of selling loans to other banks and investment houses with a process called securitizations, in which the loans were bundled. Investors could buy a slice of the bundle loan or tranche, without having to meet or assess the borrowers’ credit. As a further hedge, Easy Business Bank and Trust could take out an insurance policy with a company such as AIG and insure its credit default swaps so investors believed their money was safe.
During this setup time, all parties involved, including the credit rating agencies, insurance companies, banks, lawyers and brokers, collected large fees to process these transactions. In the Galt and Easy Business Bank example, fees make up more than 20 percent of the original $30 million, so the amount was decreased to $24 million. Yet Easy Business kept the $30 million on its books.
Now Easy Business Bank and Trust was ready to sell the $30 million worth of mortgages to friends, family, trust funds, colleges, charities and even countries. Many of these investors borrowed cash to invest in Easy Business’s offering. Investors felt safe because the tranches were insured and hedged from any downside risk.
Everything was going along swimmingly until the mortgage reset period began in early 2008. Homeowners experienced payment shock as their adjustable-rate teaser mortgages almost doubled with rising interest rates.
They could not afford the payments. Many could not renegotiate their loans, because no one knew who owned the mortgages. Their mortgages had been sliced and diced, swapped and sold off to other institutions and investors. Of the 30 original mortgages in our example, only five were credit worthy; the balance went into default.
The house of cards collapsed. Easy Business Bank and Trust’s $30 million asset-backed security was reduced by what is called the mark-to-market accounting rule. As each mortgage defaulted, the asset was marked down accordingly. As the basic asset decreased, someone had to make up the difference in value. Mark-to-market and another hedge instrument called short selling have been blamed for most of the market crash in 2008.
Because the cash flow in the original tranches dried up, there was no cash to pay off the loans used to buy the original investment. The credit default swap didn’t work as a hedge, because all the swap’s tranche mortgages defaulted. The AAA rating dropped to F. The insurance company could not pay off. The banks that loaned the money now had toxic loans. Soon, Easy Business Bank and Trust went broke.
Trust funds, colleges, charities, individual investors, investment banks, brokerage firms, countries, some hedge funds – all are unhappy. To understand the big picture in the United States, add more zeroes to the Easy Business Bank and Trust’s example. In fact, add trillions of dollars.
It will take years for economists to understand why $2 trillion of derivatives contracts, CDOs, debt, credit default swaps, asset-backed securities and tranches affected by mark- to-market came crashing down simultaneously.
In September 2008, the credit markets froze and almost all of the world’s financial institutions including Bear Stearns, Merrill Lynch, Wachovia, Citigroup, Deutsche Bank and Bank of America Securities, ran out of working capital and cash flow used to pay salaries, dividends and other expenses.
Three books are helpful in understanding all this. One is Ayn Rand’s 1957 Atlas Shrugged; it explains the philosophy of Objectivism, which holds that markets will correct themselves if left alone. William Greider’s 1987 Secrets of the Temple describes the economic gearbox used by the Federal Reserve. Gillian Tett’s Fool’s Gold documents how securitizations unleashed the present catastrophe.