How Did We Get Here?

The world witnessed uprisings last year in four Arab countries. The protesters were mad as hell, and wanted rid of the despots they blamed for their troubles. They had an agenda, and in two of those countries they managed to accomplish the goal of eliminating the scourge at the top.

In America, another protest movement arose. They call themselves "Occupy Wall Street" an aptly named group, who, recognizing that the financial calamity experienced in 2008 was caused by greedy recklessness of those in power on Wall Street, aided and abetted by those in power in Washington.

Billions were lost as the house of cards that is mortgage derivatives came tumbling down as a superheated housing market did what bubbles always do. It burst, bringing down the collateral value of mortgage-backed securities.

How did this happen? What caused this giant Wall Street calamity? What can be done to put things right, so it doesn't happen again?

The seeds of this destruction began to be sown 26 years earlier, in 1982, when, under the aegis of an actor in the White House, the powers that be began the systematic dismantling of safeguards put in place following the last major economic collapse that was the Great Depression.

It began with the relaxing of banking regulations covering the savings and loan industry, making it possible for marginal borrowers to "live the American dream."

Repeal of Glass-Steagall

I remember in 1998 when talk of Glass-Steagall repeal was circulating Wall Street, my associates and I were very skeptical. "Wasn't that law passed for a reason?" we asked.

In the Great Depression of 1929-1932, Congress examined the mixing of the "commercial" and "investment" banking industries. Hearings revealed conflicts of interest and fraud in some banking institutions' securities activities. The Glass-Steagall Act, then set up a formidable barrier to the mixing of these activities. In 1999, Wall Street convinced Congress and President Clinton to repeal this act so that the banking and insurance/brokerage giants could combine, merging the Citibank branch network with the Salomon Smith Barney brokerage and Travelers insurance. That was only the first of many, many similar combinations.

With the banks once again in the securities business, the stage was set for a repeat of 1929.

Mortgage-Backed Derivatives

In the U.S. the most common securitization trusts (mortgage pools) are Fannie Mae and Freddie Mac, U.S. and Ginnie Mae, a U.S. government-sponsored enterprise. Private institutions, like Investment Banks, Real Estate Mortgage Conduits (REMIC) and Real Estate Investment Trusts (REIT), also securitize mortgages, known as "private-label" mortgage securities. Issuance of private-label mortgage-backed securities increased dramatically from 2001 to 2007, and is where most of the problem lies.

Effect of Mortgage Backed Derivatives on the Mortgage Industry

The increased use of mortgage-backed securities created a fundamental shift or new paradigm in the mortgage lending industry. Whereas traditional lending practices required prudence in lending only to credit-worthy borrowers, now the concern regarding repayment was removed, as the original lender as "off the hook" once his loan was packaged in a mortgage pool. Repayment became the pool buyer's problem. The mortgage industry then grew like topsy, making loans to virtually all comers. "Interest only" mortgages mushroomed. Historically marginally or unqualified borrower's loan could now become part of a "subprime" mortgage pool. Everyone concerned seem to ignore the fact that one day, the borrower was going to have to "pay the piper."

Making loans to unworthy or marginal borrowers had an effect on the real estate market, as the number of buyers grew dramatically, so did real estate values, far beyond where they would have gone otherwise. This set the stage for two things: When prices reversed course, the decline would be far more severe than otherwise, and the number of foreclosures would be at record levels. I predicted this in 2004 (October).

Credit Default Swaps

When I was in the banking industry in the early-to-late sixties, there was not such a thing as "Credit Default Swaps"(CDS).

A credit default swap, similar to a traditional insurance policy, obliges the seller of the CDS to compensate the buyer in the event of default. In the event of default the buyer of the CDS receives money, and the seller of the CDS receives the defaulted loan. However, there is a significant difference between a traditional insurance policy and a CDS. Anyone can purchase a CDS, even buyers who do not hold the loan instrument and may have no direct interest in the loan. The buyer of the CDS makes payments to the seller and, in exchange, receives a payoff if the loan defaults. These are called "naked" CDS, and in fact are a "bet" on default. The European Parliament has approved a ban on this kind of CDS, starting December 1, 2011. Credit default swaps have existed since the early 1990s, and increased in use after 2003. Between the end of 2007 and mid-year 2010 the outstanding CDS amount fell from $62.2 to $26.3 trillion.

Insurer AIG required more than one bailout because they were the prime CDS issuer, and unwisely invested heavily in the same instruments they were insuring, in effect compounding their losses. The U.S. government now owns a large stake in AIG.

The Fundamental Error

I am constantly amazed at man's failure to learn the lessons of history. Contributing to the Great Depression was rampant speculation, which caused a severe imbalance as security values soared to unsustainable highs. A bubble, if you will. The dramatic gains set the stage for the decline that followed. Because the commercial banks and the investment banks were so closely linked, the failure of one lead to the failure of the other.

So, why undo the safeguards designed to prevent a reoccurrence? In retrospect, that was asking for trouble.

What about real estate values? History tells us that, as with anything valued in currency, the price has and will continue to fluctuate. If you study price fluctuations in real estate, you will see that real estate values have had a ten-year cycle, with some variations. For example, the 1986 peak was followed by the 1996 low, as prices in more volatile markets like California were halved. It seems that, in their greed-fueled frenzy for bonuses, mortgage lenders became myopic and forgetful.