Sunday, November 07, 2010
Book Review: All the Devils are Here
I got a copy of the latest big book on the crisis: All the Devil's are Here, by Bethany McLean and Joe Nocera. The bottom line: this train wreck was inevitable.
This book focuses on how mortgage lenders, rating agencies, investment banks, regulators and government agencies started down the primrose path to the final mortgage madness in early 2007. Most persons and institutions come off as petty, clueless or short-sighted, with ulterior motives masked by some public spiritness (‘financing the American Dream’). Many were clearly mistaken as geniuses during a long bull market (eg, CountryWide’s Angelo Mozillo won the American Banker's Lifetime Achievement Award in 2006). While the book tries to focus on a handful of leaders like heads of Fannie Mae, Ameriquest, Merril Lynch and others, I got the feeling none of these people were really necessary.
As the authors note, well-known financial titans like O'Neal and Mozillo were not very hands on. The authors also mention Blythe Masters of JPMorgan, another Dilbertesque manager who really does not understand the products she is officially in charge of any more than Obama understands any of the myriad large institutions he officially 'runs'. Even ignoring this, the book makes it clear that everyone was ultimately chasing profits, trying to gain or just maintain market share. The prime mover was house prices. Given this upward trend the excesses are like detailing salacious happenings at a frat party: given a bunch of unsupervised young people and lots of alcohol the specifics are both irrelevant and inevitable.
Fannie and Freddie, the big Government Sponsored Entities (GSEs) come in as a real powerhouses. The book notes an employee there saying "the same people who had power over you, whether they were congressional staffers or HUD employees or even members of Congress, wanted jobs and would unabashedly seek them." It was pretty clear that the regulators of Fannie and Freddie were puppets of the legislators who relied on the GSE perks, (Fannie spent $170 M on lobbying in the decade ending 2006). When legislators were about to rule on the GSEs they would get a "Fannie pack", which consists of every single loan originated in their district over the past 5 years. Republicans and Democrats loved this agency.
But the lobbying and legislative rot ran deep and broad. Current Massachusetts governor Deval Patrick was hired as an Ameriquest Board member and received $360k per year for this 'job'. Yet, it paid off when he stepped in to help his old pal by placing a call to Robert Rubin, getting Citigroup to inject capital into Ameriquest in 2007, and he made some fruitful calls to Obama on behalf of Ameriquest's CEO as well.
An interesting note is that some players did notice things were amiss in real time. In 2005, Greg Lipmann noted vastly higher default rates when home prices 'only slightly' as opposed to in 'double digits', highlighting that unsustainable price appreciations were necessary to prevent a collapse in these mortgages. Andy Redleaf noted that in one presentation 85% of the mortgages were to take money out of a house ('cash-outs'), as opposed to buying a house. When he asked the company executive if these had different loss rates, the exec said he did not know, but presumed they were the same. This presumption, Redlief knew, was not innocuous, and supposing it so implied a massive amount of wishful thinking.
These are the kind of signals that are interesting, because they highlight how one could have seen this all coming in real-time. Redleaf notes that it was not a handful of people who saw this coming--the theme of Michael Lewis, a great writer who is more often than not completely wrong on his main them--rather, there were about 50 hedge funds he knew of trying to short this stuff in 2006. Now, I was not close to these asset classes, so when things fell apart in 2007, I had no idea that teaser-rate ARMs had grown from 31% to 70% over the prior 8 years, or that no-documentation loans were up from nothing to 30% by 2006. Those kind of statistics were not highlighted in real time.
Worse, loan originators appear to have been on a mission that could have only ended with massive failure. For example, one firm had to come up with a policy when silly loan applicants supplied information that was unnecessary under their ‘no doc’ lending program. The extra information actually made it harder to qualify, so they found a sneaky way to erase such information (eg, documentation of insufficient income). By 2006, loan standards were basically nonexistent and such a scenario was not going to end well.
The book notes that synthetic CDOs are basically futures bets: zero-sum transactions. They do not bring in capital, they merely provide more prices, more markets. The authors suggest that the synthetic CDOs facilitated more lending, because investment banks could then hedge exposure they would not have taken. I’m skeptical that adding prices, and zero net capital, fueled the boom. Further, these markets really only grew in the final year and this catastrophe was decades in the making. Finally, the ABX index was one of the first mortgages prices to tank, and peremptorily shut down the mortgage secondary market by the end of the first quarter 2007, well before most banks shut off their lending programs (our US government is the only party unmoved by recent experience, dominating loans for under $300k).
Value-at-Risk is mentioned as if this had relevance, but I don't see how. VAR is a way to measure risk and subject to 'garbage in-garbage out'. The garbage in was the assumption that home prices, nationally, would not decline. Given that assumption, there is little risk. This isn't abstruse math, it's something my stupidest relative would understand. It is not, nor has it ever been, applicable to an entire firm including many held to maturity portfolios (ie, portfolios without market prices). I worked with VAR when it first came out, and we applied it at KeyCorp, to about 1% of our equity risk capital. For investment banks this number is higher, but it’s still small, hardly the sorcerer’s apprentice-type tool that had any effect.
So the real question is why everyone thought the market would always go up under this madness.
Several times there is a suggestion that a few regulators were thwarted in their attempts to control the market--Shiela Blaire at the FDIC, Brooksley Born at CFTC--but there's no evidence that any of their little attempts to gain more regulatory control would have mattered. First, they often had only vague objectives to ‘look at’ various questions, or have the CFTC monitor something instead of the OTS. Secondly, its not as if synthetic CDOs traded on an exchange would have necessarily prevented this problem. Lastly, it is not as if firms regulated by the OFHEO, OTS, OCC, the Fed, had significantly different behavior. Lending to people who could not afford it served many objectives and had many constituencies, and so the bottom line, that underwriting criteria weakened more and more until the end when underwriting criteria basically did not exist. The key was, given the top-down directive towards increasing home ownership, especially among the poor, this implied weaker lending standards. While later they claimed 'no one made banks lend to people who could not pay', while technically true, it was also true that regulators did nothing to discourage such lending and plenty to encourage it. 'Not force' does not imply 'discourage'.
The criticism of the rating agencies I found rather funny. They note as a critique there were 'many instances when [the rating agencies] got it wrong, usually when something unexpected happened.' Did they expect the rating agencies to predict these unexpected events? Let me know when you figure that out. To recap, rating agencies generally give the market a slightly independent view of 'quality' that is also highly informed by the market. If something trades in the market at prices consistent with a B rating, it will not have a AAA rating, and vice versa. Rating agencies do not differ from the markets for very long. However, they also do not simply ape the markets, which is why they lag them. If you think ratings are 'totally wrong', then it should be pretty easy to create arbitrage in credit markets because prices and ratings are generally consistent, and this is not so easy. However, it would be folly to defer one's credit analysis to the rating agencies if you have, say, over $100MM to invest. Like everyone else presented, the rating agencies were drinking the ‘home lending’ Kool Aid.
Borrowers are treated as victims, gouged by lenders, who then get expropriated somehow, as if the homes bought with fraudulent statements, teaser interest rates, and no money down, was something they truly owned. The authors note 'these mortgages weren't bought, they were sold'. No, they were bought too. This only worked because borrowers were getting cheap if not free options on home prices, and these options paid off handsomely in the decade prior to 2008. They enjoyed cashing money out of homes throughout the housing bubble, and those stories facilitated more willing victims who were just as greedy and short-sighted as investors. The under capitalized home owner lost less capital than anyone in this fiasco, so I don't see them as the 'losers' in this game.
In the end, all the top-level concern to increase home ownership failed. The ephemeral increase in homeownership was to people who never had the wherewithal or commitment to own homes, rather, the boom merely gave all sorts of people money they basically wasted. This highlights the folly of trying to fine-tune aggregate economic statistics, as homeownership is something you can have ‘too much’ of, as inconceivable as that might sound to some back in 2005. [Today we can’t have enough education.]
The key to a bubble is the broad asset class trend that facilitates it. This highlights why interviews on CNBC are so clichéd and vapid. I mean, really successful people seem nice enough, usually have virtues like discipline, good humor, and above average intelligence, but once they stop talking about their childhood (who didn't have interesting challenges growing up?), their big idea is often just to go all-in on a big trend that works. A really big bet like that that pays off can't be luck, many people think, because that would be an absurd amount of risk. This just highlights the maxim about confusing a genius with a bull market. It happens all the time.