Bailout Nation

by Barry Ritholtz

  Allowing banks to give money to people regardless of their ability to pay it back is at the heart of the current situation. That factor, combined with the ultralow interest rates created by the Fed to bail out the prior market crash, sent the credit market cascading toward disaster.

  As we will see, this isn’t the first time one crisis bailout led to another.

  Chapter 9

  The Mad Scramble for Yield

  [The option ARM is] like the neutron bomb. It’s going to kill all the people but leave the houses standing.

  —George McCarthy, housing economist, Ford Foundation

  As we saw in prior chapters, Alan Greenspan’s rate-cutting regime after the tech bubble burst was a radical departure from usual Federal Reserve policy. Starting in January 2001, the Fed began cutting rates—and kept cutting until they were at generational lows. The FOMC kept the federal fund rate at 1.75 percent or below from December 2001 to September 2004—nearly three years! This was unprecedented in FOMC history. Rates had never been kept so low for such an extended period of time.

  Not only had this never happened before, it was previously unthinkable. And with good reason: Ultralow rates are an enormously irresponsible action on the part of a central bank. When money becomes that cheap, there are all manner of dire consequences. Rate cuts “reflated,” then inflated the economy. But it did so at a horrific cost: • The U.S. dollar plummeted in value. From 2001 to 2008, the green-back lost nearly 40 percent of its purchasing power.

  • As the dollar tumbled, anything that was globally priced in U.S. dollars, including oil, gold, industrial metals, foodstuffs—in fact, most commodities—rallied dramatically in price. It still cost the same amount to produce/grow/mine these items, only the money used to buy ’em was worth only half as much.

  • The sole exception to this massive inflation trade was labor (this becomes important later on). With wages flat and inflation rising, Americans’ savings rate dropped below zero for the first time since the 1930s.

  • Consumers aggressively used cheap financing to buy everything, especially big-ticket items such as appliances, automobiles, and homes.

  • As rates plummeted, fixed-income managers desperately scrambled for yield.

  This last point is critical. If you want to know how home foreclosures in the United States led to massive economic disruptions worldwide, you need to understand the relationship between ultralow rates and the bond buyers. The Greenspan Fed’s radical rate policies tossed the arcane world of bond fund management into turmoil, and the net result was all sorts of unexpected consequences that continue to be felt to the present day.

  Before proceeding much further, here are a few brief words about how fund managers handle capital. There is an enormous amount of money run on behalf of large foundations, endowments, pension funds, and charitable trusts. The professionals who manage money for these institutions are constrained by some basic money management principles. Foremost among these is the payout requirement—the minimum distribution of money that these organizations must pay out each year. Each fiscal year, trusts and foundations must spend or give away 5 percent of the average market value of their assets. Failing to do so leads to heavy penalties (2 percent of assets), and the possible loss of their advantageous tax status.

  This is why any professional money manager who is handling capital for these organizations wants to safely generate sufficient income to cover the 5 percent payout obligation. Foundations want to leave the trust corpus untouched, spending or giving away only their income. A well-managed trust should last a very long time, if not forever.

  I will spare you the gory details, but it is accepted asset management theory—backed up by mathematical analysis—that over the long run, market returns eventually revert to their historic means. This basic assumption is built into models that fund managers use as the basis for their asset management plans. For stocks, expected returns are 8 to 10 percent per year. For fixed income, it’s about half of that—between 4 and 5 percent returns from long-dated Treasuries. These are reasonable long-term goals, based on a century of inflation, interest rates, market returns, and other factors.

  Hence, ultralow rates caused tremendous angst and consternation among fixed-income managers. They simply could not generate the needed returns when the Fed had driven rates so absurdly low.

  Without some other higher-yielding, yet safe fixed-income option, the trust corpus was likely to be breached.

  While market shocks occur from time to time, they tend to be within a certain measure of normal variance (mathematicians call them standard deviations). Major events that are a few standard deviations from the mean cause markets to briefly wobble, but they invariably return back to their prior trend. We saw this during such significant events as World War II, the Bay of Pigs invasion, the Kennedy assassination, the 1987 crash, the 1990 Iraq invasion of Kuwait, and the September 11, 2001, terror attacks. These were all very significant human events, but in terms of markets, they were actually rather minor.

  Indeed, these earth-shattering events barely register as a squiggle on the long-term stock charts.

  None of these events were as fundamental to the bond markets as what Greenspan did. When the Fed took rates down further and held them lower for longer than ever before, bond markets rallied and yields were decimated. (Bond yields move in the opposite direction of bond prices.)

  Hence, Greenspan induced a mad scramble among the bond crowd. The housing boom played right into this dash for fixed-income returns.

  While fund managers were scrambling for yield, the ultralow rates simultaneously set off the biggest housing surge since World War II. In the 1980s, annual home sales averaged about three million units. That rose in the 1990s to between four and five million transactions, thanks to both population growth and declining interest rates. The 1990s bull market in stocks created plenty of paper wealth, and that too soon found its way into the real estate market. Housing prices had been in a bit of slump from the 1987 crash to the mid-1990s. Once rates fell after the 2000 tech-stock crash, however, the real estate market exploded: Prices nearly doubled from 10 years earlier, and total units sold went from under four million in 1995 to over seven million houses in 2005 (see Figure 9.1).

  That meant lots and lots of mortgage financing.

  The rate cuts that were fueling the real estate boom were wreaking havoc on pension fund managers’ portfolios.

  If they could not find additional rate of return (and quick!), their clients would have to tap the permanent fund corpus—meaning use some of the principal to make annual payments. To any trustee, that was unacceptable.

  Figure 9.1 Housing Sales

  SOURCE: www.calculatedrisk.blog.com/

  The answer to bond fund managers’ prayers was found in an innovative structured product: securitized debt. Wall Street could take all manner of debt—credit cards, auto loans, mortgages, student loans—and repackage them into new bundles of new paper. Collateralized debt obligations (CDOs) paid out significantly higher interest rates than either U.S. Treasuries or blue-chip corporate bonds. And thanks to some Wall Street razzle-dazzle, they were all triple-A rated.

  From Low Rates to Exotic Derivatives

  A mortgage-backed security (MBS) is the process by which thousands of mortgages are packaged together into bondlike financial products. Holders of these instruments are actually the folks who end up getting most of the interest and principal payments homeowners make each month.

  As the graphic shows, MBS buyers can select a variety of ratings—each with a different potential risk and expected return. This is a huge liquid market: Between $1 trillion and $2 trillion in new MBSs were issued in the United States each year from 2002 to 2007.

  That’s just the first step. There are all sorts of different types of mortgage paper; some are backed by residential mortgages (RMBSs), and some by commercial property lending (CMBSs). These various flavors are then sliced and diced into various categories, each rated, and each with a different
potential risk and return to the buyer.

  If that sounds complicated, well, that’s just the start: These MBSs get sliced and diced into an alphabet soup of instruments and their derivatives: collateralized mortgage obligations (CMOs), collateralized debt obligations (CDOs), and collateralized loan obligations (CLOs). You can even insure the interest payments on these—or just make bets either way—via credit default swaps (CDSs).

  My personal favorite is CDOn—a generic term for CDO3 (CDO-cubed) and higher. These are CDOs backed by other CDOs, ranging from CDO2 (CDO-squared) to CDO3 to CDO4 and so on.

  Each of these is a more complicated instrument derived from another product (hence the term derivatives). Each new item is engineered with an increasing degree of complexity and a less transparent amount of risk. They get packaged and repackaged and repackaged further still. By the time the whole unholy mess is done, the final instrument is many, many times removed from the original paper, a simple mortgage.

  First Lien: Residential Mortgage Debt ASSUMPTIONS: Securitization rate 75 percent; loan performance reporting rate: prime and Alt-A: 75 percent, subprime: 65 percent.

  SOURCE: http://bigpicture.typepad.com/comments/files/RMBS.gif; courtesy of Credit Suisse

  Most fixed-income products come with a grade from one of three major rating agencies, Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings (more on them later). Investment-grade ratings include AAA, AA, A, and BBB. Non-investment-grade debt—also known as junk bonds—are ratings given to debt that is more economically sensitive, or whose finances are less stable, or that is highly speculative.

  Triple-A is the most creditworthy rating; this grade is only given (in theory) to the highest-quality borrowers, such as the U.S. government and top companies like Johnson & Johnson, Northwestern Mutual, Berkshire Hathaway, and Exxon Mobil.

  About now, you might want to ask yourself how this was possible: How could U.S. Treasuries be rated triple-A, and these CDOs also be triple-A rated? How could there be such a significant spread between the yields of the two assets? Doesn’t the higher-yielding product involve more risk? If yes, why did CDOs have the same credit rating—essentially, a measure of a debt issuers’ ability to pay its obligations—as bonds backed by the full faith and credit of the U.S. government (and 86th Airborne, if push really comes to shove)?

  If not, isn’t this a free lunch?

  There really are only two possibilities: Either this was a brilliant heretofore unrealized insight or it was a massive fraud.

  Rating Agencies: Moody’s, S&P, and Fitch

  Far from being objective arbiters of the creditworthiness of debt instruments, the three major rating agencies—Standard & Poor’s, Moody’s, and Fitch Ratings—engaged in a form of payola. They were willing to play along with the investment banks, putting triple-A ratings on paper that turned out to be junk—if the price was right. Call it “pay for play.”

  Working closely with underwriters, they frequently rated paper AA and AAA that eventually was revealed to be junk paper.

  Jesse Eisinger of Portfolio magazine was the first mainstream reporter to call the rating agencies out in a substantive way. He noted that this collaboration, not surprisingly, led to “benign ratings of securities based on subprime mortgages.”1 Not only did the initial ratings prove to be too generous, but the agencies were much too slow in downgrading housing-related bonds when mortgage defaults and foreclosures started to rise.

  The Wall Street Journal soon followed:

  “Helping spur the boom was a less-recognized role of the rating companies: their collaboration, behind the scenes, with the underwriters that were putting those securities together.”

  This error—placing AAA ratings on subprime-based loans and the structured products built on top of them—wasn’t merely the function of bad ratings judgment; rather, it was a conscious business decision. The Wall Street Journal noted rating agencies were active participants in the creation of structured products—not objective third-party arbiters who merely misunderestimated their creditworthiness, as the companies claimed after the boom went bust.

  “Underwriters don’t just assemble a security out of home loans and ship it off to the credit raters to see what grade it gets,” the Journal reported. “Instead, they work with rating companies while designing a mortgage bond or other security, making sure it gets high-enough ratings to be marketable.”2

  Not surprisingly, the rating agencies charged fees on crappy AAA-rated paper that were twice as big on subprime paper versus prime-based loans.3 And Bloomberg estimated that from 2002 to 2007, the agencies garnered fees on $3.2 trillion in subprime-based mortgages.

  If that sounds like it was an enormous amount of work requiring a highly skilled pool of analysts, well, not so much. Regulators found that Moody’s and S&P didn’t have nearly enough people to review all of these mortgages closely, and they didn’t adequately monitor the thousands of fixed-income securities they were grading.4

  The triple-A ratings on mortgage-backed securities were a crucial factor in the credit collapse of 2007-2008. If not for the triple-A approval of the rating agencies, much of the toxic paper that subsequently went bust could never have been bought; literally, many bond investors are prohibited from buying securities with credit ratings below a certain threshold. So the rating agencies’ triple-A seal of approval was critical to the ability of Wall Street firms to package and resell subprime mortgages and other securities now euphemistically described as “toxic.”

  It’s plain to see how historically low rates led to a housing boom. But how did something as seemingly innocent as rising home prices lead to a subprime mortgage crisis and create the great Bailout Nation circa 2008-2009?

  We’ve seen how these mortgage-backed securities were rated triple-A, the highest designation, by the top credit rating agencies. The paper was based on mortgages originated by legitimate Main Street banks. The RMBSs were securitized by the top Wall Street firms. The underlying mortgages were frequently funded and purchased by government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac.

  Buyers of these securities should have paused a moment to consider one simple fact: These CDOs rewrote the laws of economics. They promised to be as safe as U.S. Treasuries, but paid out a significantly higher yield. In other words, for the same exact risk, the reward was much greater. This should have been recognized as an impossibility. In the markets, greater reward always means greater risk. Someone would either be winning a Nobel Prize in economics—or going to jail.

  It was the financial equivalent of cold fusion. Managers were getting something (increased yield) for nothing (identical low risk). That this was not clearly recognized immediately was a function of both selective perception and cognitive dissonance. Managers wanted, needed to believe these securities could solve their yield problem. Rather than challenge the fundamental economic flaw of CDO math—greater performance for the same amount of risk was impossible—they instead simply bought into the scheme.

  Over the past few years, a variety of techniques have been employed to get more yield without taking on considerably more risk: Some managers crept further and further down the quality scale in exchange for higher interest rates. Some took on just a little more risk, hoping no one would really notice. Others borrowed money in nations with low interest rates and invested it in countries with higher rates (aka the carry trade). Some used leverage, although that has a variety of inherent problems. Some clever folks tried complexity, which hides the additional risk you are taking on from the view of most observers.

  One particular group of folks checked the box marked “All of the above”: hedge funds.

  Aggressive fund managers borrowed lots and lots of money from their prime brokers and, suitably leveraged up, went out and dove into the alphabet soup of RMBSs, CMBSs, CDOs, CLOs, and CMOs.

  Under normal circumstances, that might not matter much. However, these were not normal circumstances. The demand for these securitized products created a lan
d rush for mortgage-backed securities. From 2003 to 2007, there was an enormous creation of credit:• In 2000 the total annual issuance of mortgage-backed securities, including CDOs, had risen to more than $1 trillion. The volume of derivatives—including contracts such as options and swaps—grew even faster, so that by the end of 2006 their notional value was just over $400 trillion. Before the 1980s, these were virtually unknown.5

  • In 1990 there were just 610 hedge funds, with $38.9 billion under management. At the end of 2006 there were 9,462, with $1.5 trillion under management.6

  • Between 1980 and 2007, the volume of GSE-backed mortgage-backed securities grew from less than $200 billion to more than $4 trillion. In 1980 only 10 percent of the home mortgage market was securitized; by 2007, 56 percent of it was.7

  • According to the Bank for International Settlements (BIS), the total notional amounts outstanding of over-the-counter (OTC) derivative contracts—arranged on an ad hoc basis between two parties—as of December 2007 had a gross market value of over $14.5 trillion.8

  • Between December 2005 and December 2007, the notional amounts outstanding for all derivatives increased from $298 trillion to $596 trillion. Credit default swaps quadrupled, from $14 trillion to $58 trillion.9

  In hindsight, it’s clear this “more yield, same risk” scheme was a house of securitized cards destined to come tumbling down. But in the early part of the aughts, fund managers wandering in the desert created by Greenspan’s radical rate cutting were just discovering securitized mortgage products. To many, they seemed a reasonable way to capture the higher yields their clients were demanding. From 2002 until 2006, AAA-rated CDOs seemed like manna from heaven.