Strategy

Credit crisis: Rogues' gallery

Who's to blame for the credit crisis and where do we go from here?

“This is the best buying opportunity I’ve seen in my lifetime.”

It is 6 p.m. on Friday, Oct. 10. The Dow Jones Industrial Average has lost 18% of its value over the past five days, global markets are also down across the board, and a worldwide credit crunch is in full swing. George S. Antonopoulos, president of Wall Street I.com, a Manhattan-based wealth management firm, has just left the office after a day that saw the Dow swing 1,000 points. He is off to take his posse of employees out to Suspenders, a famed local watering hole, to celebrate the end of a long week. “You’ll never get a chance like this again,” he says. “Piling in now is how the wealthy institutional investors make their serious cash. Think about it. Right now, Ford Motor Co. is going for less than the price of a cup of coffee.”

Antonopoulos’s infectious optimism notwithstanding, there is an eerie feel this evening to the square in front of historic Federal Hall on Wall Street. A man wearing a sandwich board plastered with doomsday scenarios tolls a bell. Some people mill about the statue of George Washington, shell-shocked looks on their faces. “I do IT for firms on the Street,” says passerby Arraff Mochny. “My contracts are down 50% from a month ago.”

Over that weekend, European and American heads of state and central bankers worked around the clock to come up with a concerted response to the worst financial crisis since the Great Depression. The following Monday, their scheme — to inject capital directly into banks and get them to start lending to one another again — appeared to have worked. By end of day, the LIBOR and the TED (American and British indicators that show how willing banks are to lend to one another) had relaxed somewhat. The Dow was up 936 points over Friday’s close. Whether the strategy contains the damage to the larger economy has yet to be seen. But while the financial markets yo-yo, the blame game is well underway.

The week of Oct. 6, a lineup of chief executives paraded before the House Committee on Oversight and Government Reform. First up: Richard Fuld of Lehman Bros., who defended the millions he had made before the firm went bankrupt. Fuld claimed the bank had been “overwhelmed” by events. Yet e-mails the committee had obtained included a request submitted to the compensation committee of Lehman’s board on Sept. 11, four days before the firm filed for bankruptcy. It recommended the board give three departing execs more than US$20 million in special payments — “even as Mr. Fuld was pleading with [Treasury] Secretary [Henry] Paulson for a full rescue,” concluded committee chair Henry Waxman.

Next was the turn of Martin J. Sullivan and Robert B. Willumstad, of American International Group. Lehman’s bankruptcy had prompted a run on credit default swaps originated by AIG that had been designed as a form of guarantee on Lehman debt. Lacking adequate capital to cover those commitments, AIG agreed to a US$85-billion loan from the Federal Reserve to remain solvent. Yet a week after accepting the bailout, AIG organized a weeklong retreat for executives at the St. Regis Resort in Monarch Beach, Calif. — and ran up a US$440,000 bill. Government officials wanted to find out why this was necessary — and how executives could continue to justify their large compensation packages in the face of such failure.

The House Oversight Committee is holding three more hearings — one with the CEOs of the major credit rating agencies, scheduled for Oct. 22; one on the role of federal regulators with former Federal Reserve chairman Alan Greenspan, former Treasury Secretary John Snow, and Securities and Exchange Commission chairman Christopher Cox, on Oct.23; and one for hedge fund managers on Nov. 13.

Meanwhile, the SEC has reportedly issued subpoenas to everyone from short-sellers to management at government-sponsored mortgage issuers Fannie Mae and Freddie Mac. (Under the terms of the U.S. government’s conservatorship, which took over Fannie and Freddie in early September, chief executives Daniel Mudd and Richard Syron have already stepped down.)

Given the amount of U.S. taxpayer money at risk as a result of this crisis, government hearings are one way of apportioning blame. As Harvard Kennedy School lecturer in public policy Marshall Ganz quipped, “The Chinese used capitalism to bail out socialism. Now we’re using socialism to bail out capitalism.” But there are many other factors at work here. How the heck did the global financial system get into this mess — and who is actually responsible?

On a policy level, the debate breaks down broadly along partisan lines. Many Democrats blame laissez-faire capitalism, in which former Fed chairman Greenspan presided over an era of unusually low interest rates. That created a gusher of cheap credit that resulted in a large bubble in the housing market. Lenders and borrowers used their easy access to money to speculate in a market that some believed could never go down. Competing to secure market share in the red-hot housing sector, banks over-leveraged themselves relative to their core capital. Regardless, creditors continued to back them, purchasing large numbers of derivative assets known as credit default swaps (CDS), as guarantees against the remote likelihood of bank default. Meanwhile, investors continued to buy mortgage-backed securities, believing the diversified nature of those securities would keep them safe from risk.

Many Republicans, on the other hand, blame poor oversight at Fannie Mae and Freddie Mac, government-sponsored enterprises chartered by Congress with a mission to provide liquidity and stability to the housing and mortgage markets.

Fannie and Freddie operate in the U.S. secondary mortgage market. They work with mortgage bankers, brokers and other primary mortgage market partners to help ensure they have funds to lend to home buyers at affordable rates. They fund their mortgage investments primarily by issuing debt securities in the domestic and international capital markets. But this year, Fannie and Freddie purchased mortgage assets worth US$5.2 trillion, using leverage on a combined core capital base of US$82.3 billion. Over the summer, almost half the value of all American mortgages was put at risk as both firms teetered dangerously close to bankruptcy — before being rescued on Sept. 7 in a government bailout.

As with any partisan bust-up, there are elements of truth to both perspectives. The task now is to figure out what to do, policy-wise, to ensure such a crisis never happens again.

The case against Fannie and Freddie revolves around problems stemming from their mandate as “government-sponsored enterprises.” On the one hand, the pair are publicly traded companies, responsible to shareholders to maximize returns. On the other, their public mandate requires that they issue debt to purchase and securitize mortgages, regardless of market conditions.

Having the government effectively guarantee their debt means it is cheap for Fannie and Freddie to raise credit to buy more mortgages. Yet for much of their existence, the duo’s regulator, the Office of Federal Housing Enterprise Oversight, or OFHEO, put few restrictions on how that credit should be invested.

From 1998 to 2004, under CEO Franklin Raines, Fannie began to issue debt. It used that debt to buy increasingly risky high-yield assets — such as sub-prime mortgage-backed securities — for its investment portfolio. Meanwhile, it retained core capital at levels well below those allowed by private banks. Freddie followed suit. According to a report by OFHEO, Freddie owned US$25 billion worth of other securities in 1998. By the end of 2007 it had US$267 billion worth.

Fannie’s outside portfolio, meanwhile, grew from US$18.5 billion in 1997 to US$127.8 billion at the end of 2007. As yields on those portfolios rose, earnings per share shot into the stratosphere — pleasing shareholders, and earning management fat bonuses. (Raines’s total take was some US$90 million between 1998 and 2003.)

In a speech to Congress back in 2004, then–Fed chairman Greenspan sounded a note of caution. “Without the expectation of government support in a crisis, such leverage would not be possible without a significantly higher cost of debt,” he said.

A cutting report from OFHEO, published in May 2006, showed how this booming business eventually led to fraud. It found that from 1998 to 2004 Fannie had overstated earnings by a colossal US$10.6 billion. An OFHEO report from June 2006 found that Freddie, meanwhile, was unable to provide the public with even unaudited financials for the year prior. Both entities were asked to raise their core capital requirements by an additional 30% and install stronger accounting controls, while limiting growth.

The second act of this drama came as housing prices dived from 2006 to 2008. As values went down, Fannie and Freddie were required by law to continue purchasing mortgages from lenders, as a kind of lender-of-last-resort. By July, their combined purchases represented almost half the value of the U.S. mortgage market.

As the gap between the twosome’s over-leveraged portfolios and core capital yawned ever wider, short sellers circled. After negotiating a blank cheque from Congress to shore up the troubled pair, Treasury secretary Paulson stepped in on Sept. 7 to place Fannie and Freddie into “conservatorship” — a form of government-orchestrated bankruptcy. The cost to taxpayers has been estimated at anywhere from US$200 billion to US$400 billion. CEOs Mudd and Syron took the high dive, and mudslinging began in Congress and on the airwaves about what to do next. (Neither Fannie nor Freddie responded to requests for comments for this article.)

Like many Republicans, conservative critic Peter Wallison, once a financial adviser to the Reagan Administration and now a fellow at the American Enterprise Institute, believes Fannie and Freddie represent a significant risk to the U.S. system of housing finance, and should be unwound and privatized. But others, including House chairman of the Financial Services Committee Barney Frank, strongly disagree.

Frank, in particular, has come under fire for continually defending the two institutions. Yet in 2007, he devised a bill with Paulson to establish more stringent oversight of the duo — and got it passed last July. (Wallison describes that bill as “excellent” — if too little, too late, to squelch Fannie and Freddie’s speculative activities back in 2005.)

Frank has good reasons for defending the troubled twosome. As finance and real estate expert Susan Wachter of the University of Pennsylvania’s Wharton School of Business explains, keeping Fannie and Freddie running in a more tightly regulated version of their current format is essential to maintaining liquidity in the U.S. mortgage market. And that is necessary for the housing market to recover — thus restoring U.S. consumer confidence.

Wachter points to other factors as equally important. “[This crisis] would not have happened but for securitization and deregulation — and securitization and deregulation came together,” she said in an interview with Knowledge@Wharton, a news site run by the University of Pennsylvania. Standards eroded over time, said Wachter. “The underwriting standards literally started to come into play in 2006, where people could basically say what their income was on many of these loans.” This was possible, Wachter explained in a follow up interview with Canadian Business, because new players had come on the scene: private-label securitizers, operating under no regulatory oversight.

Why was there so little oversight? In theory, self-regulating market mechanisms make sense. When investors face real risk that their investments could result in a loss, they will modify their behaviour. But between 2003 and 2006, many players in the housing market believed that risk had been neutralized, thanks to the magic of mortgage securitization.

Securitization is the process whereby tranches of mortgages are bundled together, sliced and diced to diversify the risk they represent, and then sold on up the financial food chain. It became almost impossible to evaluate the risk these mortgages represented, explains Wachter. So instead, the banks turned to risk-based pricing — pricing geared to an automated assessment of the risk of the borrower. And with it, Wachter argues, came “the incentive to lend to riskier borrowers and to charge them perhaps more for the loan.”

Banks, mortgage lenders and investment bankers established incentives that converted the risk sub-prime and alt-A mortgages represented into fat fees for bankers and financiers at every level — from loan officers to those selling mortgage-backed securities.

Meanwhile, shoring up the banks’ ability to issue debt was a booming market in derivatives — the instruments once famously described by billionaire investor Warren Buffett as “financial weapons of mass destruction.”

Creditors concerned about their exposure to debt issued by, say, a high-rolling investment bank like Lehman, could purchase derivatives such as credit default swaps from sellers such as AIG. In the unlikely event an investment bank would default on its debt, the seller of the swap would guarantee the buyer’s exposure on certain kinds of security.

In the meantime, the buyer of the swap had to pay a premium to the seller. “It was sold like insurance, but it was not called insurance, because it was not subject to the same capital reserve requirements as insurance companies,” explains University of Ottawa professor Jacqueline Best. There were no reserve requirements, because the market in swaps is not regulated.

Why is this? Back in 2000, Congress passed a bill just before Christmas, the Commodity Futures Modernization Act. It left swaps off the list of financial instruments to be regulated by the Commodity Futures Trading Commission. “AIG was very heavily involved in this market,” explains Best. “They made money by ‘insuring’ something that was unlikely to fail” — like the debt of 158-year-old investment bank Lehman Bros.

Unfortunately for those making money off the housing boom, prices started to go down in 2006. Meanwhile, interest rates were rising. As teaser rates on sub-prime mortgages and option-adjustable-rate-mortgages reset, the cost of payments went up. Homeowners found themselves under water, where their mortgage was more expensive than the value of their home. That prompted further waves of foreclosures. And banks and mortgage lenders were left holding vast quantities of bad mortgages.

Among the most exposed to mortgage debt was Lehman. By the weekend of Sept. 13–14, the investment bank was reeling under the liability of up to US$17 billion in mortgages on its books. Unlike Bear Stearns, which drowned in March, policy-makers and bankers decided not to throw a lifeline to Lehman. So on Sept. 15, the bank filed for bankruptcy — setting off a chain reaction that saw Merrill Lynch bought by Bank of America and prompting a run on AIG’s credit default swaps. By Sept. 17, AIG had accepted an $85-billion loan from the Federal Reserve to stay in business.

According to an opinion piece in The Wall Street Journal, the acting chairman of the Commodity Futures Trading Commission, Walter Lukken, is considering legislation that would establish a clearing-house arrangement for credit default swaps. This would bring transparency and make swaps less susceptible to defaults. (With clearing houses, every seller has a guaranteed buyer, backed by the funds of the members.)

The role derivatives played in the credit crisis has some pointing a finger at none other than Alan Greenspan. “Clearly, derivatives are a centrepiece of the crisis, and he was the leading proponent of the deregulation of derivatives,” says Frank Partnoy, an expert on financial regulation at the University of San Diego, quoted in The New York Times.

Though she doesn’t mention him by name, Wharton’s Wachter also lays blame on the large bubble of credit that Greenspan’s low-rate policies allowed in the early years of this decade. (Greenspan has not yet responded to Canadian Business’s request for an interview.)

Meanwhile, Rep. Frank is among those calling for new legislation to safeguard both creditors and consumers. “In this country, there’s no law requiring that someone taking out a loan must show any proof they can pay it back,” says Frank’s spokesman Steve Adamske. “We’d like to see that changed.”

Regardless of whom you blame, one thing’s for sure: After U.S. government bailouts totalling billions of dollars, a return to business as usual is almost impossible. Robert Litan, an economist at the Brookings Institution, sums up the future as follows. “We’ll most likely see Fannie and Freddie returned to the private sector — with stronger capital requirements and more stringent oversight,” he says. “We’ll also see a regulatory reaction.” Litan pauses for a moment. “The danger here is: are we going to overdo it?”

Judging from recent antics, that’s a strong probability.“