Muggers Aren’t Heroes

If someone warned the good citizens of River City that a particular alley was dangerous, they would be doing a public service, right?

What if the reason that alley was dangerous was that they themselves were  taking the wallets from anyone who came down it?

Would you blame the fools that heard the warning and ignored it?  Would you blame the cops who said there were no dangerous alleys?

Today we were treated to the spectacle of Alan Greenspan (the cop) blaming the mugging victims (Fannie and Freddie) for the housing meltdown, all the while ignoring his own role in arming the muggers with their concealed weapon — Credit Default Swaps.

While we’re at it, give me a break on the fanciful story that the hedge funds who profited from the meltdown were the “heroes” of the story.  They did everything they could to make a profit on their anti-housing bet, including planting stories in the press to damage housing lenders, short selling stock without delivering, and calling contacts at the SEC to get investigations started.

On that last point, even though well over 95% of those investigations never found the claimed fraud, nearly 100% of the companies that were investigated had spectacular plunges in their stock prices and increases in their CDS prices.

Seems like you could make a very profitable business out of taking bearish stock, option or CDS positions, and then claiming fraud existed, whether it did or not.  I guess it’s only coincidence that the former head of enforcement for the SEC now works for a short-selling hedge fund that used to help him root out corporate fraud with well-researched tips.

Back to mortgage land, and today’s spectacular attempt to re-write history by Alan
Greenspan and the chorus of Wall Street apologists who will do anything they can to blame anyone but their contributors and future employers.  If they can score some political power points as well, so much the better.

There  are a number of reasons that the 20% down payment, fully documented loans guaranteed by Fannie and Freddie were called “prime.”  For one thing, not since the Depression had we seen a nationwide decline in house prices, and even regional declines were temporary in the 60+ years of history we had available.

That 20% down payment basically ensured that even if the borrower lost their ability to pay their mortgage, they could still sell the house and pay off the loan.  The underwriting guidelines were strong, ensuring that borrowers who kept their (verified) incomes could easily pay their mortgages, so there was, until 2008, not the potential of having literally millions of houses in danger of defaulting, at least among the loans guaranteed by Fannie and Freddie.

I can hear you already saying “I heard that Fannie and Freddie were major supporters of the subprime loan market.”  Not precisely, and this is where accuracy matters.  They were investors in the top-rated AAA bonds off those deals, and that did indeed come from pressure to provide funds for affordable housing.

NOT CRA, so just forget it if you want to push that one. Go find yourself a group that wants to re-write biology text with “creationism” or history texts that take Jefferson out and put Schlafly in, because you’re clearly more interested in political fairy tales than truth.

But let’s finish the tale of the Agencies and subprime.  First, there were no guarantees on subprime bonds (except the private deals called CDS, but more on that later).  It was the structure that provided the credit enhancement, and for the typical suprime AAA bond, that meant a combination of 20% subordination and pledging of all excess interest to cover losses before those AAA bonds would suffer.

So how did that work?  Well, in normal times, when 10% to 15% of the borrowers in a subprime pool lost their homes to foreclosure, just the excess interest covered the losses.  After all, the foreclosures were spread out over time, and each one amounted to net losses close to one third of the value of the mortgage, so the “raw” credit losses amounted to 3% to 5% of the principal balance, spread out over four or five years.  Most deals had excess interest amounting to several percent per year, so losses seldom hit any bond, much less the AAA bonds.

To cause even a minor loss (2%) on the AAA bonds, we had to imagine that half the borrowers would default, and that losses would be half the mortgages, more or less.  And it had to happen quickly – in a year or two at most. To get really meaningful losses and big profits on the CDS, the crisis had to be so extreme that half the potential buyers of houses were shut out of the market, and those who remained had to see a profit potential even without financing.

While possible, there was nothing in the history of housing markets that said it was likely.  In fact, that was the key to our friendly mugger/heroes making so darn much money.  It was considered so unlikely that it cost next to nothing to buy the insurance.  On top of that, the guys at AIG and a few of the banks truly thought those pennies they were collecting were free money.

What the sellers of credit protection couldn’t know (remember, it was the law that none of this would be disclosed) was that so many bets were being made.  As a group, the only way for the market-makers to limit their risk was to make their own bearish bets against the lenders.

The exact same game was going on the stock market.  After shorting every lender’s stock up to and past the limits of available stocks to borrow, the housing bears were buying put options on some the stocks in volumes that far exceeded even the heightened trading volumes of the companies.  Once again, market makers were forced to try to manage their risk by taking short positions in the stocks.  The beauty of the scheme was that option market-makers didn’t have to borrow or deliver the stock they sold.  They could simply inform the market that they had sold stock, and take the investors’ money.

So what happened next?  Shorting on the stock and option market forced the stock prices so low the lenders couldn’t raise new capital that way.  Shorting in the debt market via CDS forced the interest rates for these companies so high that they couldn’t borrow (especially because the banks were already exposed to the credit risk via CDS contracts, so the banks didn’t want any new exposure, no matter how much the borrower companies were willing to pay).

The bottom line was that private mortgage lending was starved for capital and put out of business.  Since that had become half the market over the years between 2001 and 2007 (up from 30%), the housing market hit its peak values in 2007 just as the trap was being slammed shut on Countrywide, Wamu, Indymac, Ameriquest, Downey Savings, Fremont, New Century, Novastar, Thornburg, and others.  We should note that by then, 70% of the subprime market in particular had been taken over by Wall Street firms, so it’s not like Fannie, Freddie, or the banks really had much to say in the outcome.

Were Fannie and Freddie stupid and over-levered?  You bet.  Were they walking down a dark alley with their family fortune in their wallets?  Yes.  Were they warned?  By a few.  In fact, they were warned by the very same people that took their wallets in that alley.



One Response to Muggers Aren’t Heroes

  1. Katie says:

    Thanks for seeing it all with an unvarnished eye and explaining it.

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