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New York Times Gets It Wrong Again: Claims Bush's Philosophy Stoked the Mortgage Bonfire ...

According to the New York Times …

“White House Philosophy Stoked Mortgage Bonfire”

“WASHINGTON — The global financial system was teetering on the edge of collapse when President Bush and his economics team huddled in the Roosevelt Room of the White House for a briefing that, in the words of one participant, ‘scared the hell out of everybody.’”

It was Sept. 18. Lehman Brothers had just gone belly-up, overwhelmed by toxic mortgages. Bank of America had swallowed Merrill Lynch in a hastily arranged sale. Two days earlier, Mr. Bush had agreed to pump $85 billion into the failing insurance giant American International Group.

The president listened as Ben S. Bernanke, chairman of the Federal Reserve, laid out the latest terrifying news: The credit markets, gripped by panic, had frozen overnight, and banks were refusing to lend money.

Then his Treasury secretary, Henry M. Paulson Jr., told him that to stave off disaster, he would have to sign off on the biggest government bailout in history.

Mr. Bush, according to several people in the room, paused for a single, stunned moment to take it all in.

“ ‘How,’ he wondered aloud, ‘did we get here?’”

Yes, it’s an interesting story …

“There are plenty of culprits, like lenders who peddled easy credit, consumers who took on mortgages they could not afford and Wall Street chieftains who loaded up on mortgage-backed securities without regard to the risk.”

“But the story of how we got here is partly one of Mr. Bush’s own making, according to a review of his tenure that included interviews with dozens of current and former administration officials.”

As I explained before, there is plenty of blame to go around. However, there are some technical issues that are rarely mentioned in the popular press.

So before reading the New York Times’ story, here are a few things to consider.

The regulatory agencies, under the Clinton and Bush Administrations had become hyper-politicalized and were often seeking media attention to boost their images as effective and efficient agents upholding the people’s trust. Truth be known, many blatant criminal acts were often overlooked as they were not sufficiently large to attract media attention or they did not involve large sums of money which could justify allocating scarce departmental resources on a violation of technical laws which could be spun any number of ways by competent lawyers. Also, under consideration was the offending firm’s finances -- if the firm lacked the wherewithal to pay “record fines” it may have also influenced the regulator’s criteria for successful prosecution. I will not mention outright cronyism and bribery as that is a story which needs to play out in the courts.

The credit ratings agencies – and the securities rating agencies – were basing a number of their decisions on outdated datasets which comprised historical default data that occurred before the onset of the borrower’s continual ability to re-finance shaky transactions and such novel inventions such as the HELOC (Home Equity Line of Credit) and the POA (Payment Option Arm) which allowed a borrower to choose their payment plan and, in some instances, skip payments. Thus the technical system’s indicators may have said all was well when the alarm should have been sounded. And let us not overlook the inherent conflict of interest between the ratings agency and their customer who was selling the dodgy securities. Like accountants, they bent over backwards to keep the business coming through the doors and the profits out of their competitor’s pockets.

Accounting rules – As in Enron-type accounting, the accounting rules promoted by the financial industry allowed organizations to sequester investments in “off balance sheet” accounts where it was next to invisible to shareholders, counterparties and regulators. Contingent liability debt, far in excess of the organization’s net worth was allowed to accumulate undetected by those whose watchdog duties should have halted the practice. It should be noted that these accounting rules were approved by the Securities and Exchange Commission. The very same commission which is forcing America to adopt looser accounting rules based on the European set of accounting rules.

Clever financial engineers – these are the people who are really responsible for the entire meltdown of the financial industry. President Bush could hardly have precipitated this crisis with his housing policies – as implied by the NYT article unless he ordered a nuclear strike on Manhattan’s financial district.

These clever financial engineers were responsible for:

  • Risk engineering – believing that they, the sophisticated financial engineers, could develop a financially engineered solution to accommodate almost any level of risk. Of course, they failed to realize that there is no way to insure against a counterparty unwilling to purchase your financial products. And that their computations rarely allowed for blatant and prevasive fraud.
  • Creation of Credit Default Swaps – an unregulated financial product designed to simulate an insurance policy. Unfortunately, these credit default swaps were not created on a sound actuarial basis, were not offered on a single exchange where one could determine pricing and exposure – and could be written by almost any organization which was believed to have a sound balance sheet. A source of spectacular profits for organizations which issued little more than “assurances” based on their assumption that the risks of the base transactions had been adequately hedged.
  • Synthetic securities – when the marketplace ran out of physical mortgages that could be used to provide the underlying collateral for mortgage backed securities, the Wall Street Wizards sliced and diced existing securities into more financial products which could be sold to willing investors. All with the complicit guarantee of the ratings agencies that most of these products were rated as “investment grade,” and thus suitable for pension funds, insurance funds, mutual funds and other capital pools which were required by law or charter to be invested in investment grade securities.

Greedy Bastards – here we must note that the entire financial system was placed at risk, not by President Bush or his Administration, but by those Wall Street Wizards and others who were not satisfied with earning an ordinary rate of return over a sufficient period of time. No! These greed-heads needed to juice their yields by investing other people’s money in these dodgy financial products. This is known as “leverage.”

In some cases, these people put up $1 million dollars in seed capital.  Then they borrowed $4 million dollars based on the net worth of their balance sheets. They then re-invested this $5 million dollars in purchasing $100 million dollars of securities. As long as there were willing buyers for these financial products and that these willing buyers were willing to accept the computerized estimates of the securities’ value, all was well. However, a downturn of only five percent, something to be expected as a normal fluctuation as time goes on, produces a loss of $5 million dollars. Thus the investor loses his seed capital and remains owing the $4 million in borrowed funds. Looking to a company that issued a credit default swap for the lost money further extends the tentacles of this multi-armed octopus. In one case, a three percent loss exceeded the entire equity of a major financial firm which should have resulted in its immediate liquidation. If not for government intervention, the company would be kaput. Instead the CEO was retired with a few hundred million dollars in gratitude payments for his ability to lose billions of dollars of his investor’s money. 

Therefore, it was not uncommon to see leveraged transactions at fifty or one hundred times being used to create enormous profits – all with the potential to generate tremendous losses in a down market.

The Black Swan …

A so-called black swan event is, by definition, a rarity – something totally unexpected. So, with President Bush, the Administration and most of Wall Street looking on, the housing bubble burst causing a downward spiral that can only now be described as the swirl and the bottom of the toilet bowl.

With the advent of foreclosures of loans that were made to people who had no business purchasing a car, let alone a home and an incalculable amount of mortgage fraud, loans defaults morphed into outright foreclosures. Borrowers wanting to re-finance their properties once again to stave off imminent financial trouble found that foreclosed properties in their neighborhood had reduced the appraisal of their property and thus were not able to get the needed refinancing to kick the financial can down the road one more time. Thus their property went into foreclosure and we saw the downward spiral increase in velocity. Many computerized models had no provisions for handling projections based on a negative real estate market and thus were spitting out useless results. Defaults were accelerating. 

Trust – the basis of all finance …

The only way I can characterize mortgage backed securities (MBS) and collateralized debt obligations is by this simple analogy. Imagine you take a few thousand mortgage notes and run them through a shredder. Then you sell each shredded piece of paper that is alleged to pay the investor a specified yield to investors worldwide. Now assume one of these mortgages defaults and you need to reconstruct the mortgage note so you can foreclose on the property and pay off the investors with the available funds. And almost impossible task.

Now, because no financial institution knows how much capital those credit default swaps that they sold will require if a redemption claim is made and they are unable to calculate the value of these dodgy derivatives they hold, they simply decide to hoard their remaining cash. That is, they will not do deals with other banks and they certainly will not lend consumers or commercial accounts money. They are frozen in space and time.

Enter the rescuers …

Some believed that all you had to do to restore trust and liquidity in the marketplace was to inject additional capital. Unfortunately, the financial organizations still did not know their capital positions or the financial strength of their counterparties, so they used the funds to acquire other financial institutions or to shore up their own balance sheets. Nothing happened.

Then the rescuers tried plan B, plan C … ad nauseam.. and found it’s still not working.

Unless there is a way to stabilize the housing market and provide a calculable floor for property, unless there is a way to satisfy or nullify the existing credit default swaps, unless there is way to unwind derivative transactions and unless there is a way to de-leverage financial operations -- the only option for the current Administration is to maintain that they are trying to solve the problem and kick the financial can down the road into Obama’s Administration. And that’s pretty much much what I see is happening today.

Go read the New York Times Story …

Now read the New York Times story and consider what petty and inconsequential politics are at play in the story. And the bitch is – it is extremely unlikely that the real culprits, the people who walked away with hundreds of millions of dollars, are unlikely to be punished or receive more than a slap on the wrist. Especially those who were politically connected and have appropriate legal representation. As for those who claim that these people had their reputations shattered, how many guests on their yacht will bring up the subject at dinner?

Yes, President Bush and his Administration were culpable, as were previous administrations and Congress. But the fault lies with the Wall Street Wizards who created and benefited from this crisis – and many of them are being rewarded with additional sums of money as they attempt to rescue themselves from their own folly.

The New York Times’ Story can be found at the link below.

-- Steve

The Reckoning - Bush’s Philosophy Stoked the Mortgage Bonfire - Series - NYTimes.com


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