Direct Public Offerings
Securitization Brought Wealth to Wall Street and Ruin to the Economy
Most financial intermediaries transform money in its passage from the providers who part with their money to the stewards who use it. For instance, commercial banks and savings banks take money into checking and savings accounts, furnishing services and paying interest. They accept deposits of all size, while withdrawals are usually available on demand. Banks also borrow money from each other and from their central bank. All of this goes into a pool, from which the bank makes loans, mostly for terms of a few months or years. Banks get their money by dealing directly with people who want the services and interest income offered. For the most part, there is no broker or other middle person.
Insurance companies take money in from the payment of premiums. Their basic function is to reallocate risk of loss—of life, home, auto, injury to others. Instead of each person having to face the possibility of a huge loss, the odds are calculated and premiums collected to spread the loss among all customers. The insurance company invests the premium monies for additional income until they are paid out to cover a loss. Many of them make loans directly to the businesses using the money.
The securities industry is a different kind of financial intermediary. It doesn’t take in money from one group of customers and lend it out or invest it in another group. Securities dealers, including investment bankers, buy securities from one group and sell those identical securities to another group. These securities come in the form of agreements between the issuer of the securities and the person who becomes their owner. Until the current age of derivatives, those securities were either bonds, for debt, or stock, for shareownership.
Most of the activity in the securities industry is in trading previously owned securities--bonds and stocks that someone wants to sell and another wants to buy. These trades are handled by securities brokers, acting as agents for sellers and buyers. Securities dealers, by contrast, use their own money to trade securities for their own gain or loss. Most securities firms are broker-dealers, meaning that they give advice and execute trades for customers, as well as buying and selling for themselves. [The Roosevelt Administration tried to separate brokers and dealers and the draft Securities Exchange Act of 1934 would have prohibited a person or firm from being both. Congress was successfully lobbied to delete that provision.]
Investment bankers are a particular class of securities dealers. They work with clients who issue new securities. As underwriters for those new issues, the investment banker technically buys and immediately resells the securities. The difference between the purchase price and the resale price is the underwriting commission.
Like most businesses, investment bankers look for ways to expand. Their business is earning a commission on money as it passes from people who have it to people who need it. A major opportunity for investment banks has been to compete with commercial bank loans. Banks make those loans from money they have drawn from depositors and from other banks. Investment bankers found they could earn fees by arranging for money to flow directly from the providers to the borrowers.
The structure for the capturing bank loan business is to create a security issued by the borrower and purchased by the investor. Without the bank’s overhead and profit, a savings in interest rate could lower the cost to the borrower and raise the rate for the provider. An issue for investment banks to overcome was liquidity—the ability for the provider of funds to take the cash back at any time. Most depositors in a bank can withdraw their money at any time, while the bank’s borrowers could keep the loan money for the agreed term. To overcome this liquidity issue, the investment banker builds a trading market for the security. That way, the provider of capital could cash out by reselling the security, without affecting the due date for the borrower.
This was the “securitization” of lending. Its first big market was in commercial paper. These securities are promises to repay money, with interest, in a period of no longer than nine months, where the money is used to pay for current transactions. They are exempt from SEC registration. [Securities Act of 1933, section 3(a)(3).] Large corporations use commercial paper to fund current operating expenses. Investors tend to be other large corporations with cash reserves beyond their current needs. During recent years, the amount of commercial paper outstanding at any time has been between 1.5 and 2 trillion dollars. [Federal Reserve Release, www.federalreserve.gov/releases/cp/outstandings.htm.]
Several investment bankers became commercial paper dealers, making tiny percentage commissions in matching buyers and sellers. Once the financial officers of large corporations got adjusted to doing without a bank, many of them also disintermediated the Wall Street dealers as well. Much of the commercial paper market is now done in direct relationship between corporations.
The next big step in securitization came with mortgage loans. Rather than dealing with single loans, investment bankers went to the banks and other institutions that had been making loans which they usually held for up to their full 30-year term. They got these lenders to put together a pool of similar loans and designed a security that would direct the loan payments to the investors.
One of the first Wall Streeters to push mortgage securities was Lew Ranieri, then with Salomon Brothers and described in Michael Lewis’ Liar’s Poker. [Michael Lewis, Liar’s Poker: Rising Through the Wreckage on Wall Street, Norton, 1995] In an interview with Business Week associate editor Mara Der Hovanesian, Ranieri was asked whether securitization of mortgage loans was necessary. His answer: “With the baby boomers, the question became how to put all of these people in houses. To accommodate the demographic demand, banks had to keep raising equity, which wasn’t realistic. Securitization allowed them to fund the loans off the balance sheet.” [“A Smart Idea Spoiled,” Business Week, July 7, 2008.] What he didn’t say was that underwriting bank equity and deposit offerings was not as profitable for Wall Street as packaging and selling loans. He also didn’t say that Wall Street had lobbied to turn the traditional mortgage lenders, the more than 5,000 savings and loan associations, into banks, so that they could sell them Wall Street products. When asked why it went wrong, Ranieri blamed “this amazing growth of the subprime industry. . . . In the name of trying to enfranchise everybody, we started creating unstable loans that were designed to blow up in two years. . . . There’s an old Wall Street adage that there’s a nexus between fear and greed. If you diminish fear, you get more greed. People got braver issuing the stuff.”
(I did a lot of legal work on mortgage securities from 1977 through 1985. We started with mortgage backed bonds, which were obligations of the lender secured by a pool of seasoned, current loans with balances equal to 150% of the bond amount. Then we put together pass-through certificates, where investors purchased shares in a pool of loans, with the trustee receiving the loan payments each month and passing them through. The next iteration was collateralized mortgage obligations, where the pool of loans was divided into groups, called tranches, with different levels of risk. During my first CMO, two things happened that caused me to decide never to do another one. First, the structure and documentation was so complex—I prepared a trust indenture of 148 pages—that investors were unlikely to ever understand what they were buying. Second, I listened to the investment bankers talk about how they marketed the riskiest tranches—even then they called them “toxic waste.” It was another 22 years before it started to fall apart in public.)
What would have happened to the housing market without mortgage securities? The existing structure would have accommodated it very well, without Wall Street. We have accommodated booms in the demand for housing in the past. Community banks and savings and loans raised their starting capital from a local community, where they also gathered deposits and made loans. Additional capital was available from the Federal Reserve System and Federal Home Loan Banks, which were financed by bond issues. For borrowers without a large down payment, the banks and S&Ls made loans insured by the Federal Housing Administration or guaranteed by the Veterans Administration.
There was not much in this system for Wall Street intermediaries. Nearly all the money used for lending came from deposits made directly by individuals and businesses. The rest of the funds came from loan repayments and from borrowings made directly from government agencies. Wall Street likes transactions where they get a commission as the money goes through. Even better is money that has rapid recycling, that keeps needing replenishing in commissioned transactions.
Mortgage securities met the Wall Street profile. They could package an S&L’s mortgage loans and sell them to pension funds and other institutions as a way to invest in residential real estate. This fit with the ERISA direction for investment managers to diversify from stocks and bonds. Wall Street had lobbied Congress into allowing S&Ls to invest outside of home loans. That way, brokers could sell products back to them, to recycle the cash coming from mortgage securities sales. Best of all, this process could be repeated as quickly as the S&L could originate new loans.
As the mortgage securities bandwagon went on, the loans made by these institutions were not enough for Wall Street. Besides, most banks and S&Ls are run by conservative people, who are under federal and state regulation. The “mortgage banker,” which doesn’t take in deposits or provide banking services, is largely unregulated. It takes very little capital to be a mortgage banker, so it’s easy to enter the business. They could originate loans entirely for the purpose of creating mortgage securities.
Lew Ranieri’s reference to the fear/greed nexus clearly did apply: “If you diminish fear, you get more greed.” Without regulators examining the loan portfolio, and without public shareowners involved, lenders had little to fear from the inevitable collapse of the subprime market. They had sold the loans they originated, without any right to return them if they went bad. The worst that could happen is what did happen—the subprime market dried up and they had to find something else to do.
“Investment banks upended the traditional buy-and-hold model for lending (which dictated prudent underwriting, since mortgages stayed on the books) and instead seized on the liquidity of secondary markets, where loans were bundled into securities and sold off to investors who assumed the risk.” [Mara Der Hovanesian, “Pointing a Finger at Wall Street: How an insatiable appetite for risky loans put big investment banks at the center of the subprime crisis,” Business Week, August 11, 2008] When the risk was being passed on to unknown investors, the people making the loans cared less and less about the quality of the loans. Subprime lending jumped from an annual volume of $145 billion in 2001 to $625 billion in 2005.” [Charles R. Morris, The Trillion Dollar Meltdown, PublicAffairs, 2008]
The well-publicized results of the mortgage securities excess were the foreclosures and declines in housing prices. But the consequences have gone much deeper. Lending standards were reduced to increase the number who could take out new loans. That meant more buyers bidding up the prices of homes. Once in, the new homeowners were urged to start taking cash out by refinancing at higher valuations. “The borrowing was possible because housing prices more than doubled from 2000 through 2005. No obvious demographic forces drove the increase; instead, it was engineered almost entirely by Wall Street.” [Charles R. Morris, “Tough Love for the U.S. Economy,” Business Week, August 4, 2008.]
One way to test whether home prices are inflated is the rent-to-price ratio. What would a home rent for and how does that compare to the sales price? When a house is viewed as an investment, the homeowner expects a return equal to the amount for which it could be rented, while looking forward to a gain on resale. The theory is that, if the rent-to-price ratio is lower than the historical average, the expectation of resale gain is higher than could be supported over time. An academic study showed the average rental amount for homes averaged a little over 5% of their resale value between 1960 to 1995. Then it dropped to about 3.5% during 1995 to 2006. That suggests that a home that would rent for $1,000 a month, $12,000 a year, would have a sales price of $240,000 at the 5% ratio. When the rent-to-price ratio dropped to 3.5%, the same house would be priced at $343,000. To get back to the earlier level, the study’s authors conclude that home prices would have to decline at a 3% annual rate from 2008 through 2012. [Morris A. Davis, Andreas Lehnert, Robert F. Martin, “The Rent-Price Ratio for the Aggregate Stock of Owner-Occupied Housing,” December 2007, morris.marginalq.com/DLM_fullpaper.pdf]
If the mortgage securities rampage did inflate housing prices, we’ll have to live with the price decline. We’ll also make our way through the collapse or bailout of investment banks, hedge funds and the commercial banks that lent them nearly all the money they used. But the consequences may go far beyond that. All that mortgage refinancing sent $4.2 trillion into consumer spending, while consumer debt went up by $6.8 trillion. As a percentage of Gross Domestic Product, consumer spending went from its 67% average for many years to 72% in 2007. [Charles R. Morris, “Tough Love for the U.S. Economy: America must endure a short, sharp recession and rein in the financial sector,” Business Week, August 4, 2008.] This caused much of our negative personal savings rate over the last few years. What will happen as that level of consumer spending dries up and people are faced with finding ways to repay debt?
Some of the greatest harm from Wall Street’s mortgage securities business was not so measurable as the losses when the inflationary bubble in housing prices burst and lending stopped. There is the harm to people who were seduced by the “do anything for the money” morality that seemed to be a winning strategy for living. This culture of greed, with its willingness to cross ethical and legal lines, often starts at the top of an organization. (When I was a lawyer for a wholesale meat company trade association, we had an arbitration to decide whether a union butcher could be fired. He had come into the plant at night through a skylight and made off with a truckload of meat. He admitted doing it but said it wasn’t wrong. To explain, he described observing management as they cheated customers, suppliers and the government inspectors. His take was just within the accepted practice.)
Unimaginable amounts of money were being made by Wall Street in selling mortgage securities. In the heat of the boom, 2002 to 2007, Wall Street received fees of $26.6 billion. [Paul Muolo and Mathew Padilla, Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis, Wiley, 2008.] In one year, 2006, the top 10 investment bankers sold $1.5 trillion in mortgage securities, increased from less than $250 billion in 2000. Investment banks began buying the brokers and wholesalers. “At the height of the frenzy in 2006, six top investment banks shelled out a total of $2.2 billion to buy subprime shops. [Mara Der Hovanesian, “Sex, Lies, and Mortgage Deals,” Business Week, November 24, 2008, page 72. The article describes the bribery, document altering and other crimes perpetrated.] The pressure was on to bring in more raw material to manufacture more securities. Big incomes were available to the mortgage bank or broker’s employees who processed loan applications and to the people who worked as wholesalers, buying loan applications on behalf of the lenders for mortgage securities.
Greed from Wall Street also infected the business of packaging student loans into securities. These became a huge and complex market. One law firm describes its work for clients this way: “The transactions in which we have participated have included the issuance of auction rate notes and LIBOR floaters backed by a pool of federally guaranteed student loans.” With the complexity came the push to make money quickly and the opportunity to perpetuate fraud. The greed virus carried through to the people who made the student loans. Since particular lenders would be recommended to borrowers by college financial aid departments, that led to favors being extended by lenders, first to the college itself in revenue-sharing agreements and then to gifts to student counselors.
Harm from the excesses in mortgage securities will take years to play out. Consider the path of the so-called $700 billion bailout rushed through Congress in September 2008. What had happened by then was that the pension funds, endowments and other mortgage securities investors decided they had bought enough. Cracks in the AAA ratings had begun to appear. Belatedly, the institutional money managers learned that loans in many of the mortgage security pools were in default and headed for foreclosure in a rapidly declining housing market.
The buyers’ strike caught investment banks with huge inventories of mortgage securities ready to be sold. Since they were held for resale, accounting rules said they had to be “marked to market,” that is, the amount shown on the banks’ books had to be adjusted to reflect the current price at which they could be sold. But they couldn’t be sold, except at going-out-of-business sale prices. As worries about their quality mounted, the buyers became sellers, competing to find someone who would take the now “troubled assets” for a price that didn’t create catastrophic losses.
What was needed, the investment bankers must have thought, was a very rich and very ignorant buyer. There must be someone who would buy at least a representative sample of these securities, at a price that was near what the bankers had paid for them. If they could make that happen, then the accountants could be persuaded to accept those sales as setting the market price. The rest of the unsold inventory could be marked to this new market and this would postpone the day of reckoning for a while. Surely, the housing market would recover and higher home prices would take care of the potential loan losses.
Who could fit the bill as very rich and very ignorant? How about Congress, the keeper of the federal purse strings, especially if they were approached just a week before the members were scheduled to leave for election campaigning? Tell them that the credit markets were plugged up by these “troubled assets,” so that farmers and small businesses could not get bank loans. Tell them that the loan money would flow again if the federal government just purchased $700 million of the mortgage securities. The first part of the plan, getting the money from Congress, worked. The rest of it did not.
There will surely be plenty of explanations for why not a single troubled asset purchase was ever made. If the Treasury had been able to pay investment banks an amount equal to what the banks paid for the mortgage securities, it might have been different, especially if the $700 million went to buy the most toxic packages. Investors might have been convinced to check out the quality of the decent securities remaining and pay a price that would not have put investment bankers out of business. But that wasn’t the program Congress authorized and the standoff continued over how to price mortgage securities.
The result has been that investment banks have had to hold onto their mortgage securities. The Troubled Asset Recovery Program was switched to a pump-up-investment-bank-shareowners’-equity-program. The federal government supported the investment bankers’ way of dealing with the problem, “betting the market will revive, the investments recover, and their profits return.” [Theo Francis, “Toxic Assets: Still No Takers,” Business Week, December 1, 2008.] The investment banks became part of new bank holding companies, giving up their historic freedom from fiscal regulation for access to capital. Actually, the strategy worked, but only for Wall Street.
The effect of this mortgage securities adventure has been to cause a recession, declared to have started in December 2007. That’s about when housing prices took a real dive. The S&P/Case-Shiller U.S. National Home Price Index, [www2.standardandpoors.com/portal/site/sp/en/us/page.article/0,0,0,0,1148433018483.html] began in 1987 at an index level of 62 and rose rather steadily through the second quarter of 2006, when it was at 190. It had declined to 180 by the third quarter of 2007, when it rapidly headed down to 150 a year later. The co-creator of the Index, Robert J. Shiller, has said that, “We had two years of warning of a slowdown before prices actually started dropping.” [Robert J. Shiller, The Subprime Solution: How Today’s Global Financial Crisis Happened and Want to Do about it, Princeton University Press, 2008, page 67.] He attributes our failure to see that the bubble would burst to “the myth that, because of population growth and economic growth, and with limited land resources available, the price of real estate must inevitably trend strongly upward through time.” [page 69]
This myth about ever-increasing housing prices has served the interests of all the intermediaries involved in assembling and selling mortgage securities. The government rescue proposals they put forward seemed to be designed to restarting the bubble, using below market financing to cause artificial demand for home purchases. A December 2008 plan was to have the government subsidize mortgages at 4.5%, bringing in buyers who couldn’t afford to pay another percentage point or so. As Robert Shiller said, “The idea that public policy should be aimed at validating the real estate myth, preventing a collapse in home prices from ever happening, is an error of the first magnitude. In the short run a sudden drop in home prices may indeed disrupt the economy, producing undesirable systemic effects. But, in the long run, the home-price drops are clearly a good thing.” [Robert J. Shiller, The Subprime Solution: How Today’s Global Financial Crisis Happened and Want to Do about it, Princeton University Press, 2008, page 84]
There is no reason to believe that this is the end of the subprime mortgage securities game. Many of the mortgage brokers who had originated the subprime loans have become licensed as lenders for the Federal Housing Administration, where they can get federal government insurance for up to 100% of the loan amount. Goldman Sachs, the investment bank that got $10 billion of “troubled asset” bailout money and was the first to issue FDIC-insured debt securities, purchased control of a subprime lender and got it licensed to originate FHA-insured loans. It purchased $760 million of subprime mortgages for 63% of their face value, to refinance into FHA-insured loans and resell them for 90% of their face value. [Chad Terhume and Robert Berner, “The Subprime Wolves are Back,” Business Week, December 1, 2008, page 040.