March 12, 2009

• More Sexy Money Talk

  How many people think that the Community Reinvestment Act and the liberal Congress who forced banks to lend to poor minorities without a clue how to handle the responsibility of homeownership is the true cause of the mortgage crisis?  How many people think that Fannie Mae and Freddie Mac were taken down by the overwhelming number of poor people who defaulted on their mortgage?  There are so many myths floating around out there that it’s hard to know what’s really going on.  Have you heard these?

  MYTH 1 – CRA caused it.

  As a banker required to pass annual tests on the Community Reinvestment Act and at least 20 other Banking Laws and Regulations covering the A to Z’s of lending, it’s amazing to me how many people feel free to blame CRA for the mortgage crisis when they obviously have no idea what CRA is or what it forces banks to do (or not). 

  Here’s the myth:

  “Congress imposed sanctions and fines on banks that did not lend to a sufficient number of minority customers, regardless of their creditworthiness or ability to repay a mortgage. Banks found themselves having to make these subprime loans.”

  Here’s the truth:

  CRA does not require a bank to lend money to anyone who doesn’t qualify for the loan, period.  The Community Reinvestment Act doesn’t fine banks or punish them for failing to lend.  What CRA does is keep a scorecard of the amount of local activity a bank performs.  When and IF that bank ever desires to merge with another bank, a low CRA score can result in the Fed refusing to approve the merger.  That’s it.  That’s all it says. 

  There is NO Federal or State Banking Law anywhere that ever requires a bank to loan to anyone who doesn’t qualify for the loan.  On the other hand there are multiple organizations including the Federal Home Loan Bank, FDIC, Federal Reserve and others that come in regularly and evaluate the collateral for the loans any given bank has on the books.  If that collateral is weak, the bank IS fined, given strict supervision guidelines, or can find itself taken over by the Fed with it’s collateral sold for pennies on the dollar to another more solid bank.  That’s a pretty strong disincentive for banks to loan money to weak borrowers. 

  Banks are subject to anti-discrimination laws.  So if, for example, a bank has a habit of approving loans to green people at an interest rate of 5%, but only approving loans to equally qualified purple people at an interest rate of 10%, the bank can be fined and have it’s CEO Spraypainted Pink in the Public Square. 

  Every year regulators come and look at a random sampling of loans made by a particular bank.  The regulators bring their own calculators and hole up in a back office with food they also bring themselves in hermetically sealed containers lest someone from the bank accidentally befoul the process by offering them a sandwich (I’m exaggerating – a little).  They spend weeks glaring at everyone suspiciously and asking a lot of questions. 

  The idea that the regulators come in and fine banks who fail to lend to a certain number of minorites is good drama, but it’s not true.

  MYTH 2: Fannie Mae and Freddie Mac did it.

  “This crisis started in our housing market in the form of subprime loans that were pushed on people who could not afford them. Bad mortgages were being backed by Fannie Mae and Freddie Mac, and it was only a matter of time before a contagion of unsustainable debt began to spread. “

  Oh really?  The market share of Fannie and Freddie. in the years 2004 to 2007, never came close to its level before the junk market took off. According to data from the Federal Reserve Board, Fannie and Freddie securitized $315.2 billion worth of mortgages in 2002, accounting for 50.1 percent of the new mortgage debt that year. In 2006, they securitized $276.0 billion in mortgages, giving them a market share of just 34.8 percent.

  When you look at the Subprime Market, Fannie and Freddie had even less of an impact.  Between 2004 and 2006, Fannie and Freddie went from holding a high of 48 percent of the subprime loans to holding about 24 percent, according to data from Inside Mortgage Finance. 

  And did they relax their standards so much that they were brought down by the high default rates of the loans Fannie and Freddie purchased?  The data is available at the Fannie Mae site.  The Serious Deliquency chart includes everyone who is 90+ days late on a single family home loan, or 60+ days late on a multifamily home.   These are very conservative data because not all these homes will get to foreclosure, but they are the ones most likely to go there.  The serious delinquency rate is 2.4% on Single Family and .30% on multifamily homes. 

  That’s a rate at or below the historical default rate.  Compare that to data from Moody’s Investor Services which announced last month that 42% of all subprime loans are seriously delinquent and that as many as 50% of all subprime loans could be in default by the end of the year. 
  
  It’s starting to look like Fannie Mae and Freddie Mac are the only good news out there. 

  MYTH 3: It’s less risky to play with money than have unsafe sex.

  In spite of the fact that Fannie Mae and Freddie Mac have very low default rates, they’re in trouble.  So how is that?  Their woes are easily explained if you understand the twin dangers of exaggerating the size of your equipment and swapping sex partners. 

  The executives at Fannie Mae and Freddie Mac, just like all the big boys, got paid based on how many times they scored.  Now as I pointed out above, for several years straight, they weren’t scoring.  They were in fact losing market share hand over fist.  They were losing because in spite of the rumor that they were cheap and easy as the crack whore on 4th and Main, they actually had standards.  But they were talking the talk like, well, like one of those rappers who really came from a nice middle class family with a nice home, made straight A’s, walked the dog, and had a curfew, who writes lyrics about blood, guns, needles, and wife-beating.

  Most of the loans Fannie and Freddie were buying were Prime loans made to people with substantial downpayments, excellent credit, stable employment histories … boring vanilla people.  Which means boring vanilla returns on investment.  So the accounting geniuses at the two agencies cooked up a scheme to make it look like they weren’t boring.  In fact, they cooked up a scheme which seriously misrepresented the size of their … ahem … portfolio.  Congress thought they were regaining the share they’d lost, and the execs at the top got nice sexy bonuses. 

  Then they got audited.  And once they were naked it was kind of hard to pretend anymore. 

  That’s when things get really weird.  See in the mortgage investment world, everyone is subject to everyone else’s … portfolio.  They got hooked up together in a kind of mutually assured destruction pact called credit default swaps.  Credit Default Swaps work like a big net.  Company A sells bonds.  Company B buys them.  But someone at Company B gets a bad feeling that MAYBE Company A might not be as solid as the financial statement implies.  So Company B goes to Company C and says “Hey, I have a $100 bond from Company A, I’ll pay you 3% a year for every year I hold it if you’ll guarantee me that you’ll pay me the face value if Company A fails.”  So far, that’s straight insurance right? 

  Well, Company C agrees to insure that bond.  THEN Company C, which doesn’t own anything related to Company A goes to Company D and says, “Hey, I have an interest in the health of Company A.  Would you insure that they are good?  I’ll pay you for that service.”  So now, Company C is hedged.  If Company A defaults on the bond, C will pay B but D will pay C so Company C has a net loss of 0.   

  So every one is happy.  A has money, B has a bond, C has a hedged bet.  And when you look really close you see that eventually the circle closes when A buys a bond in D and starts the process all over again.  

  The amount that a Credit Default costs depends on how much risk the other companies think is involved in the company in question.  When the books at Fannie and Freddie were questioned, suddenly no one knew how much they were really worth even though they knew they were worth something.  Now, if I’m Company C, I’m not going to agree to insure you if I think I really might have to pay, or if I am willing to insure it it’s going to be for a lot more money.  Instead of 3% I’m going to ask … 40% or 60%.  And no one in his right mind is going to pay that kind of protection money.  Even Tony Soprano would have had a tough time selling that deal. 

  If Company B which is in the habit of buying my bonds can’t get insurance for my bonds, Company B is not going to buy any more bonds.  So now, I’m Company A and I need some money.  I have a boatload of loans on my books and I know the money will come in eventually, but today my payroll is due so I need money today.  And no one will loan it to me because they think that maybe I’m only a tease.  

  That’s what happened to Fannie and Freddie.  Their trouble had nothing to do with poor people getting loans, their problem was with wealthy gold-chain wearing, smack-talking CEO’s who wanted to be a little more wealthy.  So last September the Federal Finance Housing Authority, stepped in like Richard Gere in Pretty Woman and paid $100 billion for the exclusive right to Fannie Mae’s services.  Good for Fannie, not so good for everyone involved in insuring Fannie. 

  And now we’re at the part of the blog where I usually try to come up with a cool conclusion, but the truth is that we’re not at the end of this story yet, and might not get there until sometime in late 2010.  It’s like a soap opera.    Tune in tomorrow for the next installment …  

  • 10:33 pm
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