Musings on the Financial Crisis

From my warm, sunny apartment here in Nice, France, the problems of the global financial markets seem very far away. But I don’t let them stay far from my thoughts: I am an avid reader of the International Herald Tribune, the local Nice-Matin, and receive online updates from the washingtonpost.com, economist.com, nytimes.com and of course, Yahoo, and am an active listener of BBC radio, in addition to the local French stations, and almost militant about making sure that I am home from 12:30 to 1:30 each day and then again from 7:30 to 8:30 each evening so that I can catch the national news shows on my French TV. I have a friend in Washington actively engaged in trying to dissect the cause of the crisis, and receive articles to read on a regular basis from him as well. Early on, I thought I’d write up an article with my perspective of the crisis, and wrote that first draft at the end of September, but realize now that my perspective came only from my time at Fannie Mae, and in the weeks since then, it has become increasingly obvious that the problems at Fannie and Freddie were just one small part of the overall problems that have devolved into a global Financial Crisis.

I’ve been trying to look at the current situation from a regulatory standpoint, based on my four years as a enforcement attorney at the Securities and Exchange Commission, and from my ten years of consulting to the financial services industry, which included assisting many of my clients with regulatory compliance projects. My inside/outside perspective is not unique, but it allows me take a broader-based view than some of those currently writing about the crisis and proposing regulatory reform.

The more we learn about the contributing factors to the financial markets meltdown, the more the picture becomes murky. The fact that Fannie Mae and Freddie Mac took on subprime and Alt-A mortgages into their portfolios was not, as the government would like to have us think, the cause of the mortgage crisis. Fannie and Freddie were each performing their function as a government-sponsored entity (the former better than the latter, by all accounts, even in my biased opinion) and fulfilling their mission in providing a liquid market for mortgages. Those firms, taken over by the Feds in early September, have become bit players in the overall saga that has unfolded on Wall Street and around the world.

The housing bubble was growing throughout first half of this decade. As home prices began their steady and rapid rise, homes became less affordable to average Americans. So mortgage companies began to make available “affordable” mortgage products that would ease the traditional 20% down, fixed rate mortgage that had been the market norm. Adjustable rate mortgages, also a common product, were traditionally designed to take advantage of rising home prices, and were sold with the expectation that the homeowner would be able to refinance the home subsequently at a lower rate, once the price of the home had appreciated. But in the new environment, these loans were modified to make them more affordable, and hence, more risky, for the homebuyer. Subprime loans, which had been traditionally offered to homeowners seeking equity loans, became products for first lien mortgages in this effort to make homes “affordable” for first time homeowners. And in the frenzy of rising home prices, the marketing of homeownership as a right, and property ownership as a quick way to make a buck, caused ordinary Americans to behave irrationally, and ignore obvious risks, even as they were disclosed to them. There has been much discussion of fraud in the mortgage lending market, of which there certainly was some; in any time of rising fortunes, there are participants who greedily make plays for more than is legally allowed. But one can also listen to media interviews with homeowners since the bubble burst, who acknowledge that they entered into a home purchase not fully understanding what they were getting into, but understanding also that they were taking a risk bigger than they had ever taken before.

Studies by members of the Federal Reserve, as well as academics and practitioners, show that the mortgage products themselves did not cause the mortgage crisis. In fact, most of the products had been available for many years. But the manner in which they were used, and the type of buyer who took advantage of those products, coupled with sinking home prices, caused the default rate that presently rears its ugly head over the states of California, Florida, and Nevada, among others. The prepayments of mortgages, common with homeowners, for example, who took on fixed rate mortgages to buy a new home and then refinanced with a fixed rate mortgage, ceased once home prices started to fall. Unable to refinance, and unable to pay the newly adjusted mortgage payment, those home owners were the ones who were among the first to default on their loans.

Meanwhile, as home prices and the growth of mortgage backed securities grew, the market for collateralized debt obligations on non-agency bonds grew, and the credit derivative swaps market evolved. And blossomed, and burgeoned, and soon that market was dwarfing the market of the asset-backed securities on which the swaps were based. So, when housing prices began to fall, and mortgages began to default, the securities began to lose value, and the parties were forced to pay obligations (that most purchasers had never thought would come due, despite their own risk assessments), and found themselves losing money, and/or in the awkward situation that they had no idea how much money they had lost. While the traditional mortgage-backed CDS securities were carefully constructed for particular buyers, the non-agency subprime market in CDSs was new and the guidelines for triggers and defaults were based on guidelines for other types of corporate derivatives, not the unusual characteristics of the asset-backed securities of the credit derivatives swap market.

I’ve been doing some reading about the subprime debacle, to better understand how it impacts our current financial crisis. The book “Subprime Mortgage Credit Derivatives” (Wiley Press, 2008) reviews the credit derivatives market that grew using as collateral the loans issued in the non-agency mortgage market, that is, loans not written to specifications mandated by the GSEs, Fannie and Freddie. These are the loans that stretched the “affordability” standard discussed above. The authors argue that, based on their review of subprime mortgage loan data, and the performance those loans, specifically when reviewing the performance of the ABS CDO and CDS markets and the performance of the associated ABX and TABX indices, the subprime mortgage loans written in 2006 were “the worst ever created by man (except for 2007).” (page 303). The authors do a detailed analysis of these loans and their default rates, concluding: “The results of our tranche by tranche analysis are depressing from a credit standpoint. Subprime mortgage bonds and ABS CDOs are the biggest credit and risk management failure ever.” (page 291).

The authors hypothesize that the quality of the 2006 loans was affected by two factors. The first, that “the traditional relationship among FICO, Loan-to-Value, mortgage document type or doc type, debt to income ratios and defaults failed to hold for the 2006 book of business.” (page 303) The second argument they make for the deterioration in loan quality is stronger, based on their analysis of the data:

“The main culprit, in our opinion, is the unobserved underwriting variables and the extent to which originators were willing to push the envelope in underwriting these mortgages. In a booming housing market, loans leveraged to the hilt (CLTV > 100, low doc, purchase) are most prone to being underwritten with the loosest guidelines. But as housing turns, these loans will show the weakest performance. In such an environment, overreliance on FICO proves fatal, as it had become the last line of defense (and with loose underwriting, turned into a line of sand). So it is no surprise if many originators pushed the envelope on FICOs, (e.g., thinly filed FICOs, comingling of borrower and co-borrowers’ FICO and income). Such mortgages are also the most likely candidates for inflated appraisals. We suspect lenders loosened such secondary criteria as time on job, time in home, time since last bankruptcy, and so on, criteria that never makes [it] into a term sheet. In essence, loans with seemingly similar or even identical reported characteristics would perform very differently in this environment.” (page 70)

This further bolsters the argument that the mortgage companies that perpetuated the bubble by creating more and more risky loans was an act of complete irrationality.

Lack of regulatory oversight is an oft-quote phrase in the writings and press reports of the past month and year. But it has also been well documented how the opportunity to regulate certain products was bypassed by Congress, and efforts to coordinate the regulation of products between the SEC and the CFTC have stalled continually over the past decade. Hedge funds are the current target of the popular press and regulators, as fingers have pointed to these unregulated firms as the buyers of the CDS and other highly leveraged and risky products in the mortgage market. Certainly transparency in what they were doing, and where the bulk of their investments lay, could have given regulators a better sense of the overall derivatives markets, and an early warning of the ungainly size of the leverage of many of the firms. But the very nature of hedge funds is that they are private, and that their educated and wealthy investors agree to invest their funds for the expertise and risk that come with those firms.

I’m still doing some thinking about a regulatory approach. More to come.