Why banks aren't the bad guys
And Regulators and Big Government Is: excerpt from my upcoming book "A Conservative on the 2009 Housing Recovery"
In the vacation markets real estate speculators drove an irrational exuberance with myths and stories of huge returns with “no risk” of ever having to purchase the underlying property. This is really where the whole “bubble” talk started. As early as 2002 I can remember investors from the Chicago area flying to Florida to look at proposed condominium sites for investment flips. They would put down perhaps $20,000 per unit and then the sales organization for the developer would work to sell the units to others in return the investor would get back their money plus a share of the increase. The developer was able to use these funds in the interim to secure construction lending and tell the bank they had a sizable portion of the units pre-sold.
Enron, yeah Enron, and for that matter Tyco and other high-flying CEO’s at public companies caused investors and regulators to look more squarely at off-books transactions and balance sheet manipulations. Frankly blame the investors here, for desiring continual and regular increases in income from a world where regular is myth. Fannie Mae and Freddie Mac, private companies with implicit government guarantees at that time, were caught up in the balance sheet manipulation game and needed more fee income for their bond securitizations to keep investors and regulators happy. We'll look with more interest at Fannie Mae and Freddie Mac later, but suffice it to say no company can serve two masters. You are either a government entity, and the regulators are your boss; or you are a shareholder entity and the shareholders are the boss and take the risks.
Congress stepped in after Enron and Tyco with the motto “It’s OK, we’re from the government and we’re here to fix everything” and passed Sarbanes-Oxley a ridiculous expense creating monster with little or no positive effect unless you were an attorney or accountant. It was interesting this last week to watch the Madoff crisis on Wall Street, knowing that the SEC nor Sarbanes-Oxley overregulation could do anything about a true securities criminal. Shame on the investors again for wanting something that can't be had.
Oh yeah, I forgot while on the subject of government over-stretch, banking regulations also “required” or ORDERED banks to make loans in targeted bad neighborhoods to keep their charters as banks. Community Reinvestment Act (CRA) loans were then given looser standards, or no standards at all to meet these ludicrous requirements. This program was drastically increased under President Bill Clinton with banks being told, lend in the inner city or lose your charter to operate.
Banks decided the only way to off-set the sure losses from CRA loans, was to also expand lending to these loose standards in other communities. The thought was to balance almost certain losses in CRA targets with gains in non-CRA communities. Some liberal economists have scoffed at my point, and have suggested what we need is a lot more regulation. They are biased, in general the science of economics tends toward central control and even socialism, it's just plain eaiser to control and predict when less people have any power.
Loans were created to allow 100% financing on real estate. Other loans allowed self-employed borrowers, always tough to lend because incomes rise and fall each month, to “state” an income and support it with assets or credit scores. These were not all bad loans, to this day and with all the talk of a bubble burst and credit crisis foreclosures are still less than 25% of all these sub-prime, ALT-A and other composite loans.
During this period of steadily loosening requirements for a mortgage under the now famous Sub-Prime and Alt-A lending phase, the securitization of mortgages become extremely complex. Typically a mortgage loan is originated by a local bank or mortgage broker and then actually funded by a larger mortgage banker/company. These loans are then packaged together into big pools and the payments are used to secure bond financing in the open market. This entire process started to become very difficult to understand, but investors kept buying without asking for details. The transparency that we all assume exists in the market, where investor knows what they are buying, was slowly dissolved to the point of complexities that only super-computers and PhD's could understand.
During early 2007 the demand for housing began to decline off records in previous years, this is a regular occurrence and we all know there’s a roughly 7 year housing cycle. This demand reduction though, this time, was reported as the beginning of the housing bubble burst by major media. Real estate professionals, never wanting to be left out, jumped on the bandwagon and decried to one and all “Housing is dropping, sell and drop your price now." I fault real estate professionals with losing their professionalism generally. Want to create chaos in a movie theater? You yell "fire" and watch as people rush the doors.
Regional banks also decided at this in-opportune time to dramatically decrease their exposure in construction and real estate lending. Some banks shut down their entire lending departments and told staff remaining to be prepared to take part in wholesale auctions to get rid of everything else. Thus began the credit freeze. Though some friends in banks have confronted my theory with a contrary view: regulators stepped in at this time and ordered banks to cut real estate lending for fear of losses and banks did what they were told. What an interesting parody of thoughts, the regulators ordering banks to reduce exposures to real estate, while the Treasury Sec. and Congress is complaining that banks have frozen all lending.
Like a run on a bank, when confidence wanes, markets and consumers over-react and over-sell their assets for fear of being stuck with them. Couple this phenomenon with legitimate concerns about speculators in vacation markets and you have pressure on values and immediate increases in inventories. Oldest economic theory in existence, when supply is high and demand soft, prices decline.
Investors finally decided to look deep inside their bond portfolios and found to their dismay higher foreclosure rates from Sub prime and Alt-A mortgages than they expected. Why they didn’t expect higher defaults no one knows, I can remember many a time asking “why are these loans priced so low, shouldn’t they be above 10% for the risk inherent in less documentation?”
Large mortgage companies came under attack first, with the removal of hundreds of higher risk programs and demands that they make things right quickly. Well they couldn’t and in reducing the number of products they offered, their stocks were battered by their stock holders. Many of these large mortgage companies went under and the survivors are weak and incapable of helping create a housing recovery.
One such company was Countrywide Home Mortgage, once the largest in the nation. Once again CEO largess and a board of directors who said nothing about spending untold millions on themselves and the officers, the company began a slow spiral. There will be some that will suggest that this was due to Sarbanes-Oxley, not even close to the truth. The biggest issue was that programs were removed, ones that they made millions selling, and that now were considered too risky. Countrywide was battered, sued, regulated, torn apart and sold off to Bank of America when the stock became nearly worthless.
A note on mark to market – I can’t say that I’m any kind of expert on this rule, but clearly the mark to market rule forces portfolios to be reviewed and marked down if the assets “might” be worth less in the future. When default rates began to be a problem, especially in the speculator vacation markets, this created a need to mark down some of these portfolios for possible future problems. The bond fund manager needed to either cover these short-falls or raise more capital. We'll talk more later about some easy fixes to this margin call problem in the future, but suffice it to say that with 80% of all mortgages still performing quite nicely these bond funds are getting decimated for lack of being able to raise billions in cash to cover the calls. Remember most of the loans are still current and paying, but they are being marked down to ridiculous lows to facilitate an arbitrary and capricious regulation.
During the beginning of 2007 raising more capital at banks was costly but possible, but the more the media talked about a pending recession the less possible. Banks were freezing all lines of credit and non-bank investors were having a hard time taking risks expecting a recession.
Step in the government again, with a monster move to take over Fannie Mae and Freddie Mac. Congressional leaders even going the extra mile to talk bad about banks that were potentially also in trouble. Government action to broker a sale of Merrill Lynch to Bank of America began to look and feel like a major problem was brewing. Note that now Bank of America now controls the once largest mortgage company in the country and one of the largest securities firms, Countrywide and Merrill Lynch, both purchased with government assistance and insistence at pennies on the dollar.
Remember 2008 is election year, and all the talk so far has been about how poorly the Bush administration has “managed” the economy. Note the irony, George Bush had nothing to do with foolish speculators, with under-priced Alt-A loans, or with Sarb-Ox. But he’s supposed to manage the entire economy and protect investors and banks from themselves. Sadly after 7 years of providing pretty conservative and solid leadership, even George Bush began to cave to pressures of economic calamity and legacy.
Oil runs to $140 a barrel on speculation that we really don’t have enough oil for a solid global economy and thus gasoline runs up to $4.00 or higher in many parts of the country. Guess what, when a big chunk of every families’ income goes up three fold, they cut back on other consumer goods. Once a family pays 40 or 50% of their income to the government in taxes, then gasoline to get to work, for housing and basic needs; retail discretionary purchases will have to be reduced if the others are grabbing more and more money.
Enter the October stock market drop, banks being taken over by the FDIC, and lending grinding to a halt. Congress, and this time President Bush too, decides to throw more money into the system to fix it. They craft a $700 Billion bailout bill, initially a few pages long and eventually many hundreds of pages long with pork and regulatory foolishness. They throw the first couple hundred billion at a few chosen banks, and guess what? The banks start buying other banks and still won’t make any loans to consumers or small businesses. Congress cries foul, but the die has been cast, when regulators demand that banks shore up their balance sheets they do so at the demize of lending.
Sound fanciful? Sound like I have an axe to grind? On the former it’s not a fictional story, this all happened in the course of the last couple years, and THE major player in the whole works was the government, with an unquenching need to step in and makes things worse and worse each time. On the latter, we enjoyed our home building company and all the things we learned. Early in 2007 we were informed by our key banks that they were under pressure from their regulators to reduce real estate exposure and that they could really only finance homes that were pre-sold, so no new specs. We totally understood that decree, since specs were selling slowly and gathering low bids anyway.
Then on one fateful day in August of 2007, we had 7 pre-sold homes to close. Homes that we had worked on as a team for six months, and closings we really needed because the market was a lot slower than at any other time in our 10 years of business. On that day we received word that three major mortgage lenders had gone out of business, and none of the 7 homes we thought were sold and ready to close, would indeed close.
Those seven buyers did not close, even though none of them were trying to hurt anyone or destroy the market. I laid off my entire staff within the next two weeks, closed the doors, and began the process of fighting with the very banks that turned off the spigot.
No one in our company was a speculator, a ponzi schemer, an abuser or scammer. We fought to build homes for mainly first time buyers using every financing tool legally obtainable in the open market. No, I don’t have an axe, but I’m mighty sure that the media and bankers and government regulators that destroyed this market need to removed and replaced with Americans who believe in the American Dream. Not an American Dream of handouts or entitlements, but an American Dream of rugged individualism and self-worth.
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