On NPR Talking Subprime: What I Didn't Get to Say

So I had a little cameo today on NPR's On Point program titled The Mortgage Bailout Debate. On the air at the same time as me were Robert Shiller (Yale, author of Irrational Exuberance, you know the guy) and Robert Kuttner of The American Prospect. Two very smart guys. The tone of the discussion swayed from "How could those bankers have gotten paid millions of dollars only to get bailed out; how come the heads of the Wall Street firms haven't lost their jobs?" to "There are some fundamental flaws in our regulatory system that need to be addressed." Clearly a mix of populist rhetoric and economic substance, which I guess is necessary to both engage listeners and further the learning process. But I'd like to say what I would have liked to have said if I had more time to spar with the Bobs on-air.

First, let's take a step back. What were some of the forces that gave rise to the subprime mess in the first place? Here is my own short list (in no particular order):

1. Cheap debt a/k/a accomodative Fed policy
2. Abundant investor liquidity
3. Lack of sensible know-your-customer standards in mortgage origination
4. CDO investors who didn't do their homework and/or relied on rating agencies
5. Bank investors who didn't do their homework and understand the potential impact of off-balance sheet vehicles
6. Rating agencies lack of experience in dealing with CDO credits of such complexity
7. Poor accounting rule-making

Now if you look at this list and then say 'How many of these problems did Wall Street create?", my answer would be "precious few." What Wall Street is exceptionally good at is taking advantage of the rules. They make sure they know the rules very, very well, better than any other constituency on the planet. Then they innovate, develop, structure and sell based upon delivering customers (be they issuers or investors) value in a form that enables them to make money. Risk sharing and mitigation. New asset classes for investment. Greater liquidity. These are all good things. Say what you want about Wall Street, but one thing I haven't heard in the sea of criticisms of late are the words "illegal" or "fraud." That's because they did nothing wrong. They did what the current screwed-up regulatory construct (hello, Congress?) and the markets (hello, What me Worry? investors?) allowed them to do. So take a look in the mirror before throwing stones, all ye critics. Because odds are that you play a part in this crisis as well.

Mr. Kuttner made the comment that "SIVs were new and invented by Citigroup, I think." Wrong. SIVs and their intended use has been around in a variety of forms for decades. Operating leases, sale/leasebacks, asset defeasance transactions - these are all geared around keeping assets off the balance sheet. Thing is, analysts (at least those who are sentient beings) know this, and good ones properly capitalize these off-balance sheet exposures effectively undo this accounting imagery in their models. Investors should be doing this as well, and if they don't, too bad. Problem is when investors who are stewards of mutual funds, pension funds and other fiduciary vehicles do dumb things it is everyone who suffers. Not just Wall Street. Main Street.

Mr. Shiller made a point I agree with very strongly, that our fractured, decentralized regulatory infrastructure is woefully inadequate given the rapidly increasing scale, complexity and globalization of our financial markets. We do need a single set of rules for areas where market inefficiencies necessitate regulation, and one which both Bobs mentioned and which I agree with relates to underwriting standards. I am personally less concerned with the standards themselves than I am the "Know your customer" concept that already exists at retail brokerages both outside and inside Wall Street firms. This same concept needs to be enforced on mortgage originators, in order that customers will only be shown products that are appropriate given their income, job stability, etc., because it is clear that there were widespread abuses of people originating paper that never should have been written in the first place. And coordination of regulation between states and the Federal government is critical for clarity, which will make regulation easier and facilitate innovation.

So if you were to draw a picture of the problem with arrows and a big SIV in the middle, you've got loans in on the left, some good, some bad, into the SIV, and then CDO paper out. Retail investors need better protection on the left, in my opinion via know-your-customer and product appropriateness standards. CDO investors, many of whom relied on ratings agencies to make their purchases, need the confidence to be able to trust the integrity of the agencies and the quality of their analytical work. Right now, both issues are in question. That said, investors need to do their homework, over and above an implicit "seal of approval" from the rating agencies. And none of this addresses the accounting rules, which still enable off-balance sheet structures that defy both economics and logic. That is a post for another day.

I am glad these issues are being hashed out in public. I just wish that they were more dispassionate in their approach, leave the populist rhetoric to the side and to focus on the underlying problems that need to be fixed. Because there is a whole lot of fixing to do, and griping about Wall Street salaries is not going to get us there.   

Comments

[Roger]

jcb, that sure is. and using this logic thread, are the rating agencies going to be called to the mat for colluding with the banks? ugly. thaks for the article.

[JCB]

Is this fraud?

First American sued over alleged appraisal scheme
Worked with Washington Mutual to inflate home appraisals, suit charges
By Alistair Barr, MarketWatch
Last Update: 2:01 PM ET Nov 1, 2007
SAN FRANCISCO (MarketWatch) -- New York state's attorney general said Thursday that his office is suing First American Corp. for allegedly "colluding" with mortgage lender Washington Mutual to inflate the appraisal value of homes.
First American's eAppraiseIT subsidiary succumbed to pressure from Washington Mutual, also known as WaMu, to use a list of preferred "Proven Appraisers" who provided inflated appraisals, according to Andrew Cuomo, New York's top law-enforcement official.
Emails show that executives at eAppraiseIT knew their behavior was illegal but went ahead in order to secure future business with WaMu, Cuomo said in a statement.
Representatives at Santa Ana, Calif.-based First American and at WaMu didn't immediately respond to phone and email requests for comment.
"The independence of the appraiser is essential to maintaining the integrity of the mortgage industry," Cuomo said.
However, First American and eAppraiseIT "violated that independence when Washington Mutual strong-armed them into a system designed to rip off homeowners and investors alike," Cuomo alleged.

[baileyman]

Back when I was a sell side, then a buy side analyst on these mortgage companies, it became clear to me that the guys driving the business were the bond bankers.

They were constantly on the prowl for originators to latch onto for a fee stream. Their financing was designed to promote growth and to protect the bond investors, but also to take all the value out of the companies. They knew the companies would eventually fail, and avoiding the fallout was imperative.

It's not like the companies were saints, though, as their model was essentially the same applied to their borrowers.

This business model morphed into an equity game, too, where it became possible to sell the residual equity even though the bond bankers had usually corralled all the value for their investors. Maybe it's not illegal the bond bankers didn't inform the equity bankers of the reality.

This was all pre-bubble, though. Since this time housing has sprinted 70% above trend value. Now we're looking at a situation where people believed they could diversify away the overvaluation. But that's not possible.

I measure the downside as about $90,000 for the median homeowner. That'll hurt.

[Roger]

JCB, when I am talking about litigation, I am not talking about anyone and everyone that has invested in subprime paper. The litigation surrounding Bear's busted funds has nothing to do with subprime and everything to do with failure to disclose and false advertising. What I am talking about is that the issues giving rise to the distress are fundamental - inappropriate loans, bad credit decisions, inexperienced credit analysts and poor investor due diligence. This is not an issue of fraud. It is an issue of a badly broken system. Will there be lots of lawsuits? Sure. But for issues clearly unrelated to fraud and maybe, only maybe, issues of illegality in the lending process. But that's the real story. Not he Bear Stearns-type issues.

[JCByron]

"but one thing I haven't heard in the sea of criticisms of late are the words "illegal" or "fraud."

Then you must live a sheltered life! Many participants have liability - Bear has already been sued by class action and by the state of Massachusetts. Merrill has been sued by customers. This is the beginning and much more to come. Congress has already raised "assignee liability" so you know where their thinking is. This will be a field day for lawyers and there will be big hits all around imho

[Yaser Anwar]

Sir,

What do you think about developing a new business model for the rating agencies by promoting competitors that would be paid by investors in securities rather than their issuers?

A law prof at CBS has suggested the SEC to calculate default rates for each rating agency and make that information public. Do you think that's feasible given that the SEC is always understaffed?

Y

[Roger]

hps, based upon the logic inherent in your comment and the tortured metaphor used to make the point I might think you are a user, not a trafficker or a promoter. first, selling mortgages isn't illegal. selling heroin is. second, taking out a mortgage isn't addictive, heroin usage is. third, i very clearly stated on both NPR and in my post there are big issues early in the transaction chain, where the appropriateness of mortgages sold to certain homebuyers require legislation and regulation. this can create a safe environment for their use, where there is no safe environment for heroin use. this sould help solve many problems, as the mortgages originated would likely be less complex, the analysis required to assess their credit by rating agencies more straight-forward and investors' due diligence on pools much, much easier. so while I appreciate the poignant nature of your example, it simply doesn't work in this case. thanks for playing.

[hps]

Yah, and don't forget that heroin addiction isn't the dealer's fault, but rather a problem of the buyers (improper due diligence) and the screwed-up legal/regulatory regime. And the dealers didn't invent heroin either!

Disclaimer: I am neither associated with nor compensated by heroin traffickers.

[Mt57]

Real good post, thank you.

[Yaser Anwar]

Can you please post the video when you have time? Thank you.