PDA

View Full Version : How it all began


CanadaSue
12-21-2008, 12:29 PM
This is an excellent read for dudnderheads like me who don't operate in the world of big finance. It's a bare bones, (very few numbers), great & simplified explanation of where the subprime mess originated - an excellent backgrounder with the absolute basics needed to understand the roots of this:

SINCLAIR STEWART AND PAUL WALDIE , From Saturday's Globe and Mail


The rise and fall of Lehman Brothers

NEW YORK/TORONTO - Richard Fuld sat still in his chair and stared straight ahead, facing his interrogators with a clenched jaw and the occasional flash of defiance.

He had been summoned to Washington on this chilly October morning to answer for the demise of Lehman Bros., a storied Wall Street firm that under his 15-year watch had staged a remarkable revival – and suffered an equally breathtaking collapse.

At least that was the ostensible reason. But now, as one congressman after another took turns grilling him over his lavish pay, and juxtaposing this with the financial plight of ordinary homeowners, it became clear that he had been brought here to answer for something much larger: the role of Wall Street in sparking the biggest economic meltdown in more than 80 years, a crisis that threatened not only long-lasting hardship, but a loss of faith in the very free-market system that had fashioned the country into a superpower.

“If you haven't discovered your role, you are the villain today,” chided John Mica, the Republican representative from Florida. “So you have got to act like the villain here.”

Mr. Fuld had been carefully chosen for the part. With his example, the lawmakers could provide angry Americans with a simple explanation of what went wrong, of how the reckless pursuit of self-interest among brokerage executives, traders, hedge funds and other financial types had fuelled the subprime mortgage binge and incited the biggest economic catastrophe since the Great Depression

The hearing was a crash course in how the financial system has evolved in the postwar era. It showed, through the prism of Lehman, how banks had moved away from traditional services, like making loans and underwriting securities, to complex and risky forms of financial engineering.

This proved to be a momentous shift in the capital markets, one that accelerated over the past decade to create what is known, ominously, as the “shadow banking system” – an unsupervised, $10-trillion (U.S.) financial playground whose size now rivals the traditional banking industry.

This was a world populated by arcane instruments like credit default swaps, special investment vehicles, and collateralized debt obligations. These instruments were spread through every corner of the financial world, and their web of interconnections was so intricate that no one – not their creators, and certainly not the investors who lapped them up in search of higher returns – could forecast the damage they might wreak if the system came under stress.

They were, as billionaire investor Warren Buffett vainly warned, “weapons of mass financial destruction.”

Black Monday, the day in September that Lehman declared the biggest bankruptcy in history, will be remembered by a generation for sounding the death knell for this shadow system.

And thanks to Congress, which was looking to provide an enraged country with a healthy dose of catharsis, that same generation will likely remember Mr. Fuld as the face of Wall Street avarice and treachery – perhaps even as the face of the crisis.

This might have been good theatre, but it was a woefully incomplete explanation of how a U.S. housing problem mushroomed into a global calamity – of why countries like Iceland nearly collapsed; why chastened auto makers have trudged to Washington, hats-in-hands; why pension funds from Norway to Australia find themselves in the grip of massive deficits; of why the commodities markets have withered, stunting the growth of developing economies.

Wall Street may have created the financial architecture that abetted the crisis, but it was by no means a lone actor. Indeed, when one takes a closer look at Lehman's participation in the housing market, and how this market eventually infected whole economies, all sorts of troubling questions emerge: questions that Congress quickly glossed over in its excoriation of Mr. Fuld.

For instance, why were investment banks allowed to borrow massive amounts of money to make risky bets? How could a shadow banking system, one ten times bigger than the Canadian economy, be allowed to flourish so quickly without any oversight from government regulators? Why were credit rating agencies stamping dubious products with their approval? And how could homeowners with poor credit histories or zero documentation, let alone jobs, qualify for mortgages?

In its haste to hand Americans a villain, Washington had failed to look to itself.

Home ownership has always been the most tangible embodiment of the American Dream. From the start, landless immigrants were drawn by the opportunity to own property. Later, as the country evolved from an agrarian society into a more urban one, the purchase of a home remained the key expression of upward mobility.

But home ownership wasn't merely about the collective aspirations of ordinary Americans: It was also viewed by government as an agent of social improvement and cohesion. In the 1920s, President Herbert Hoover said families who owned their own homes provided “a more wholesome, healthful and happy atmosphere in which to bring up children.” His successor, Franklin D. Roosevelt, avowed that “a nation of homeowners is unconquerable.”

During the Depression, millions of Americans defaulted on their mortgages, and thousands of banks collapsed. Mr. Roosevelt responded in 1934 by creating the Federal Housing Administration, an agency that provided government insurance on long-term mortgages and regulated their interest rates. These longer-amortization mortgages helped to ease down-payment amounts and made it easier for people to keep up with their monthly mortgage tabs.

The president also introduced what became known as Fannie Mae, a government agency that purchased the now federally insured mortgages from banks and other financial lenders, allowing them to issue more loans. Within the span of a couple of years, Washington had become the key player in several aspects of the mortgage market, and before long it was promising “a decent home and a suitable living environment for every American family.”

The result wasn't merely an increase in home ownership levels, but a shift in expectations. With government making it an explicit policy goal, home ownership became less about aspiration and more about entitlement – regardless of whether people had the means to pay for a house or not.

It wasn't long before popular culture reflected this sentiment. Who can forget George Bailey, Jimmy Stewart's character in the 1946 film It's a Wonderful Life, upbraiding the slumlord Mr. Potter, who wanted to scrap home loans for the poor?

This dream of home ownership took root in the postwar years, and ownership levels rose steadily, buoyed in large part by the flowering of suburbs across the country. By the late 1970s, however, this policy of enfranchisement via property hit a snag.

In 1977, President Jimmy Carter moved to make housing more affordable by requiring banks to lend in low-income neighbourhoods. But before the decade was out, the scheme was stymied by record-high interest rates, courtesy of an inflation-fighting Federal Reserve Board.

Savings and loans institutions (or “thrifts”), which accounted for more than half of all mortgage lending, faced limits on the amount of interest they could charge on mortgages, as did conventional banks. When the Federal Reserve rate shot up to 10.3 per cent in 1979, almost double what it had been three years earlier, many lenders found themselves in a pinch. In some states, market interest rates were higher than the ceiling on mortgage rates, meaning banks and savings and loans institutions would actually lose money when they offered a loan. So in many cases they didn't.

The roadblock inspired a pair of policy responses that would ultimately lay the foundation for the ascendancy of subprime mortgages.

Congress responded first with the Depository Institutions Deregulation and Monetary Control Act, a sweeping piece of legislation passed in 1980. The most far-reaching part of the act concerned mortgages: DIDMCA would scrap state usury limits on mortgages, allowing lenders to charge whatever they wanted. Moreover, the act would wipe out these rate limits for any company – regardless of whether it accepted deposits – that lent more than $1-million a year.

“This … is the statute that ultimately set the stage for the subprime home equity lending industry of today,” Cathy Lesser Mansfield, a professor at Drake University, wrote in her 2000 examination of usury deregulation. There was virtually no discussion in Congress, she noted, of what sort of predatory lending tactics might take hold if mortgage rate ceilings were eliminated.

DIDMCA on its own didn't revive slumping house sales. With interest rates so high, and the country tipping into recession, fewer Americans were enticed to borrow. Once again, a desperate Congress sought to revive the market with deregulation. In 1982, shortly after Ronald Reagan came to power with his laissez-faire convictions, the U.S. government moved again, introducing the Alternative Mortgage Transaction Parity Act.

Congress noted that the rate environment was making it difficult for consumers to get long-term, fixed-rate mortgages, so it further loosened the rules, allowing lenders to promote a hodge-podge of “alternative” mortgage features. These included adjustable-rate mortgages, “negative amortization” loans (whereby borrowers don't pay off the principal), and “balloon” mortgages (which oblige borrowers to make a large payment at the end of the loan's maturity in exchange for lower monthly charges).

These “alternative” mortgages figure prominently in the current crisis, either through predatory lending, or poor risk controls, or hidden punitive charges that tipped people into foreclosure. Taken together, these two legislative overhauls opened the door wide for small consumer finance companies to pile into the mortgage business and begin peddling exotic, high-interest loans. Several of these upstart companies were already busy at work, waiting for just such a break.

Brian Chisick was always a salesman. Born in London, England, he moved to Vancouver with his parents at age 14, but dropped out of Kitsilano Secondary School after Grade 10 to start making money. Tanned and fit, with a jutting jaw and barrel chest, he turned his hand to peddling a variety of products.

By the late 1960s, Mr. Chisick and his wife, Sarah, had landed in Los Angeles, right in the middle of the postwar housing boom. They soon found something new to flog – loans.

Demand for loans was high, but regulations were tight and banks weren't interested in lending to people who didn't have a solid credit background.

Mr. Chisick gravitated to “hard money” lending: second mortgages and loans to people turned down by banks. Rates were slightly higher and the loans were secured by “hard” assets, such as cars or furniture.

After learning the ropes at a variety of hard-money outfits, in the late 1970s, Mr. Chisick and his wife co-founded First Alliance Corp.

His timing was perfect. The changes introduced by presidents Carter and Reagan in the early 1980s allowed Mr. Chisick to charge higher rates, and then use these to tempt investors into buying the loans he issued.

His pitch was a simple version of what he and other mortgage originators would later turn into the engine of the subprime machine. Investors would get the monthly payments from borrowers, whose loans carried a higher interest rate than bank mortgages. Mr. Chisick took the money from the resale of the loans, plus a fee, and then made more loans.

Finding borrowers wasn't hard. Mr. Chisick put dozens of ads in small papers and mailed out stacks of flyers. Finding investors proved more difficult. Mr. Chisick bought lists of potential investors, and then called them one by one to pitch the benefits of buying a loan.

Within a few years, First Alliance had half a dozen loan officers and a dozen investment counsellors – small-time, low-ranking salesman. Later, as First Alliance and other originators grew, the salesman role would be assumed by high-powered Wall Street investment bankers, at Lehman and other blue-chip firms.

Mr. Chisick's model was so clever and that it wasn't long before others around Orange County began to take note. They helped start nearly a dozen subprime lenders, including eventual giants Option One Mortgage Co., New Century Financial Corp. and Ameriquest Mortgage Co. Over in another Los Angeles suburb, Countrywide Financial Corp. was launched.

But for the regulators that would later do battle with many of those companies, Mr. Chisick remains the godfather to the subprime lending world.

“We always say [the Chisicks] were the start of it all,” says Chuck Cross, former director of the consumer services office in Washington state. “They were the first of the big bad predatory lenders. In many ways they were much worse than some of the big ones like Ameriquest to come along in subsequent years.”

Mr. Chisick secured notoriety with regulators because of the savvy marketing techniques that he perfected. He also displayed an early knack for getting firms such as Prudential Securities and Lehman to help bankroll him.

To target borrowers, Mr. Chisick developed a profile of the most likely First Alliance customer: middle-class, preferably white, in his or her late 50s. The best candidates had been in their homes at least 10 years, and had built up about 30 per cent equity in their property. But most crucially, these people had other consumer loans or had fallen behind on tax payments and were therefore viewed as unattractive risks, or subprime borrowers, in the eyes of traditional lenders.

Mr. Chisick believed these borrowers would be the most receptive to his brand of high-priced second mortgages and loans. And if they ran into trouble, First Alliance would get a property with substantial equity.

Mr. Chisick spent up to $20-million annually to locate people who fit this profile. By the late 1980s, the company was sending 1.9 million pieces of mail every month to neighbourhoods carefully targeted from local tax records, real estate databases and credit records. He even bought lists of people who were delinquent on their taxes. “We would call them to see if we could give them some money,” he said in a deposition in 2002.

A month's worth of mailings generated about 2,500 inquiries, which were fielded by a team of telemarketers. All promising prospects were referred to First Alliance's loan officers, who typically generated about 270 loans from each monthly mailing, according to documents filed in court.

The loan officers were the linchpin of the operation. Most were former car salesmen, well schooled in slick pitches. Each officer had to memorize a script, called the Track Manual, that outlined a 13-step presentation that was made to potential borrowers. To make sure they got it right, Mr. Chisick put new recruits through four weeks of videotaped rehearsals and role-playing with other officers.

The objective of the Track was to obfuscate the fees and terms of a First Alliance loan. For example, according to court filings, step 8 in the Track – dubbed “The Monster” – “tells the loan originator to divert the consumers' attention from the loan transaction that they are about to sign onto.”

One judge later said the presentation “was so well performed that borrowers had no idea they were being charged points and other fees and costs averaging 11 per cent above the amount they thought they had agreed to borrow.”

While most banks were lucky to make $4,000 in fees on a $100,000 loan, First Alliance pocketed as much as $20,000, according to state regulators.

By selling these second mortgages – essentially refinancings – Mr. Chisick had turned government policy on its head. He wasn't putting more people in homes, but encouraging homeowners who were already deemed at-risk by traditional lenders to take on additional debt.

This wasn't all that easy to do amid a depressed economy and soaring interest rates. But once again, luck intervened for Mr. Chisick in the form of Washington lawmakers. Until 1986, Americans could deduct interest payments on most types of consumer loans. But under President Reagan, the government wanted to simplify taxation and eliminate a range of shelters. Interest deductibility was no longer allowed, unless –and this was a big exception – it was the interest consumers were paying on their first or second homes.

Not surprisingly, people began to use their homes as piggybanks. Why take out a separate loan when you could borrow against your house, and be able to write off your interest payments?

Calculations by Ms. Mansfield of Drake University show that home equity loans grew from “virtually nothing” in 1983 to “about $40-billion” by the end of 1986, while second mortgage indebtedness more than doubled to a record high of about $150-billion in 1986. And by 1988, a scant two years after the tax code was changed, 68 per cent of home equity loans were used to fund things other than home improvements, compared with just 35 per cent in 1984, according to another study.

As companies like Mr. Chisick's grew exponentially thanks to the regulatory changes made during the 1980s, Wall Street reacted by devising new and more complicated ways to help them sell their loans to investors.

The most crucial innovation was the privately issued mortgage-backed security. In the old days of banking, a lender would issue a mortgage, and then hold it on its books until the loan was paid off. But now Wall Street saw a way to generate ever more lending revenue – it could pool these mortgages, turn them into tradable securities, and sell them to large investors.

Banks, thrifts, and mortgage originators like Mr. Chisick, meanwhile, could create a lending assembly line: By selling off their loans, they continually freed up room to issue more of them.

Securitization in itself was not a new phenomenon. Fannie Mae and Freddie Mac, the two quasi-governmental mortgage giants, had securitized mortgages and sold them to investors, but there was a big difference: These were mortgages backstopped by the U.S. government, thus viewed as safe for conservative investors such as life insurance companies, investment managers and pension funds.

In the mid-1980s, credit rating agencies began to rate the emerging, primitive form of mortgage-backed securities. This imprimatur encouraged large investors to begin dipping a toe in the market. Between 1984 and 1988, the percentage of home mortgages that were securitized jumped from 23 per cent to 52 per cent.

As the demand for these securities grew, lenders in turn sought more and more people to put in homes, a dangerous spiral that would inevitably force them to scavenge for loans among borrowers with dubious credit quality – the type Mr. Chisick's company targeted.

Suddenly, mortgage finance companies like First Alliance demonstrated massive growth. Regulatory sea-shifts had allowed them to waltz into the housing market and charge whatever they wanted for mortgages. The interest-deductibility change effectively turned homes into automated teller machines, and companies like First Alliance were only too happy to step up with the money for refinancing – again, at rates of their choice.

And Wall Street's securitization engine, though still in its infancy, began pumping out mortgage securities so quickly that lenders were scrambling to write more new mortgages to keep up with investors' demand.

In 1977, these little consumer finance companies owned a mere 0.5 per cent of the home equity loan market. But by the end of the 1980s, they had 32 per cent.

The Chisicks became multimillionaires. They bought a 5,000-square-foot mansion in Anaheim and had a $2-million house in Los Angeles and a condo in Hawaii. They became active in the Jewish community and made big donations, including one that put the Chisick name on a local auditorium.

Indeed, the real estate grab was so lucrative that pretty much everyone – brokers, lenders, investors and rating agencies – increasingly turned a blind eye to the risks. And why not? If banks were no longer holding onto these mortgages, and brokers were simply finding them for a fee, what did they care if borrowers eventually found themselves unable to pay the bills?

Although home ownership was reaching record levels, the government's series of rule changes had unwittingly charted a dangerous new course – one that, in the recent testimony of a former high-ranking mortgage executive, would transform the dream of owning a home into a nightmare of foreclosure.


http://ctv2.theglobeandmail.com/servlet/story/RTGAM.20081219.wcover20/business/Business/businessBN/ctv-business

gsgs
12-21-2008, 01:09 PM
3447 words.

13 charts would have been better, IMO

CanadaSue
12-21-2008, 03:10 PM
Words are always more interesting than charts.

DReynolds
12-21-2008, 05:19 PM
Words are always more interesting than charts.
Hardly.

CanadaSue
12-21-2008, 05:45 PM
If it comes to very basic explanations, why shouldn't they prove more interesting to many? At the very least, basic explanations such as these help give a rudimentary basis upon which one can build an understanding of more specific charts.

DReynolds
12-21-2008, 05:57 PM
If it comes to very basic explanations, why shouldn't they prove more interesting to many? At the very least, basic explanations such as these help give a rudimentary basis upon which one can build an understanding of more specific charts.

Basic is good. But whereas anecdotes and metaphors are subjective, and subject to interpretation, charts contain data. For example, IMO this article's reference to Jimmy Stewart's character in "It's a Wonderful Life" serves to distract and paint a caricature.

rootdiggr
12-22-2008, 06:08 AM
Throw a bunch of charts at me, my eyes glaze-over and I quickly move on. This article I have copied to a word document and can read and ponder. Thanks Sue.

gsgs
12-22-2008, 06:47 AM
with words you can usually "prove" any point ... as well as its contrary.
See politics,religion,literature. It just depends from whose point of
view you consider things.

So people invented science.

CanadaSue
12-22-2008, 11:11 AM
I didn't see this, when I posted the article, as an 'either/or' situation. I saw it as a simple, (simplistic?), explanation of the roots of subprime & the ensuing messes it created.

It's one question that's been bugging me since this aspect of the financial world began stalling, then collapsing - how the heck did this all ever start? The article provided a fairly short & reasonable looking, bare bones explanation. Clearly such an article couldn't begin to cover the many complexities of this business & it doesn't look as though as it was meant to.

It simply provides a reasonable starting point for anyone wondering about the source of all these problems today. You can take the artice & by doing some research, easily flesh out the many missing details & other aspecs of finance that played into this.

A.T. Hagan
12-22-2008, 11:25 AM
Black Monday, the day in September that Lehman declared the biggest bankruptcy in history, will be remembered by a generation for sounding the death knell for this shadow system.

Not hardly. Just its evolution.

.....Alan.

BirdGuano
12-22-2008, 01:11 PM
Black Monday, the day in September that Lehman declared the biggest bankruptcy in history, will be remembered by a generation for sounding the death knell for this shadow system.

Not hardly. Just its evolution.

.....Alan.

Yep, it evolved right onto the back of taxpayers and duped foreign bond buyers. :beer: