The Dukes of Moral Hazard: The Dangers of Quantitative Easing

 

This brilliant and terrifying column was originally published at ProPublica and is republished here under a Creative Commons license. cc

by Jesse Eisinger
ProPublica, Nov. 10, 2010, 2:40 p.m.

sinking_shipAcross the world, there are booms. Chinese Internet companies are flourishing. Energy companies are finding new sources of power. Commercial real estate is coming back.

Unfortunately, this isn’t happening in the real world, which is still crippled by sagging economies, but in the investing one.

If there’s a doggy stock, a dodgy loan or a slice of a complex credit security made to a questionable borrower — hedge funds want it now. Companies with junk bond ratings are flooding the markets with new issuance. If private equity firms bring a money-losing company saddled with debt to market, investors are eager to snap it up.

Thank the Federal Reserve. The central bank has embarked on its program of “quantitative easing,” a second round of experimental monetary policy in which the Fed buys up assets — like longer term government bonds — to bring down interest rates, which is supposed to spur lending and borrowing, thus reigniting the economy.

Nobody knows whether it will work to bring down the intractable rate of unemployment. But it has already worked in one significant way: the speculative juices of the markets are flowing.

What’s going on? As a Fed official explained it in a recent speech, one supposed benefit of the Fed policy is that it will add to “household wealth by keeping asset prices higher than they otherwise would be.”

So it’s levitation-by-decree. When the Fed moves, financial assets receive the opposite of collateral damage: universal blessing, deserved or not. Lower rates may or may not help more people find work. But there’s no doubt that the central bank has already helped the Henry Kravises and Lloyd Blankfeins of the world.

The Russell 2000 stock index, which is made up of smaller companies, has risen about 21 percent since September, when investors started to anticipate that the Fed would intervene in an aggressive fashion. A tiny Chinese Internet stock, China MediaExpress Holdings, is up more than 250 percent since mid-September. The private investors that own Harrah’s, the money-losing casino company, are bringing it public, and investors are going to gamble on it despite a crushing debt load.

Then there are something called B notes, bonds backed by commercial real estate loans. B-note holders are on the hook for the early losses if the loans go bad. They are as hot a commodity as everything else. Never mind that there’s a huge oversupply of commercial real estate in this country. Or that Wall Street just went through a disastrous episode for complex structured financial products of exactly this sort.

Without knowing a thing about finance, here’s how to tell it won’t work out well. Wall Street is the great master of the euphemism. The Street doesn’t call them junk bonds; they are “high yield.” Here, something isn’t just Triple A. It’s “Super Senior Triple A.” So when the best investment bankers can do is to dress something up with a lowly “B,” you know it’s trash.

Leverage, meanwhile, has made a glorious return. Interactive Brokers, a discount brokerage firm, has been running an advertising campaign that displays money spewing from printing presses. The firm will lend (for certain special customers)$566,000 for every $100,000. Ah, borrowing heavily for the purposes of trading in volatile markets. Maybe some Bear Stearns or Lehman Brothers bankers can explain the wisdom of this.

All of this is Finance 101. The cheaper money is to borrow, the more it makes sense to take a bigger risk with it.

But that doesn’t make it more palatable. It feels like an ominous replay of recent Federal Reserve emergency actions, which led to bigger and bigger bubbles. The Fed brokered the rescue of Long-Term Capital Management, bailing out the investment banks that had lent to the collapsing hedge fund. The Fed pumped money into the economy to save us from the Y2K computer bug. The Fed tried to rescue the economy from the bursting of the Nasdaq bubble, helping to create the housing bubble.

It’s like the exhausted “Saw” movie franchise; this isn’t just a sequel. It’s more like the third iteration of the second reboot — harder core, baser and for serious liquidity heads only.

Is this the price society has to pay for a better economy? Do we care if some hedge funders get rich as long as unemployment goes down, fewer people get thrown out of their homes and household debts are less crushing?

That would be a worthwhile tradeoff. But it’s far from clear that the Fed can get any real traction with its policies.

Over the past year, I’ve been investigating some of the more egregious conduct that occurred in the bubble years. In this column, I’ll be monitoring the financial markets to hold companies, executives and government officials accountable for their actions.

A main focus will be the spectacle of returning speculation. It’s commonplace to lament Wall Street’s lack of a historical memory. But there is something different at work. Professional investors have learned the lessons of the financial markets’ serial bubbles and learned them well.

The lesson is: When the next one comes, I’m going to get mine. I’ll just get out early this time.

You can contact Jesse Eisinger at jesse@propublica.org

Today’s non-news: Millionaires optimistic while the rest of us worry about paying the mortgage

First from the Wall Street Journal:

Millionaire Optimism Hits 3-Year High

Now, the Washington Post:

Most Americans worry about ability to pay mortgage or rent, poll finds

Well now. I feel much better informed.

palm slap

Increase in foreclosure rate could mean banks knew they were seizing properties they didn’t actually own

In the 3rd quarter of this year banks repossessed a total of 288,345 properties – by far the largest quarterly total since the meltdown began. The 4th quarter of this year is likely to have the fewest repossessions of the meltdown because of “the decision by several of the largest lenders to halt filings after it was discovered that paperwork for many loans is missing or incorrect.” The increase is a sharp spike in the total number of repossessions. The 4th quarter numbers were a 7% increase over the previous quarter and a 22% increase over the same period of 2009. According to RealtyTrac: “A record total of 102,134 bank repossessions were reported in September, the first time bank repossessions have surpassed the 100,000 mark in a single month.

So, did the banks know what was coming and try to get as many properties safely in to their possession as they could before the hammer came down? If this is not the case then why the increase?

Now I am not a real estate lawyer – to put it mildly – so I don’t know the answer to the following: Is it legal for banks to foreclose if they know that they cannot substantiate ownership? My guess is no. I hope the 50 state attorneys general now looking into this hunt around for any signs of foreknowledge by the banks. If the banks were doing something they knew to be illegal – as opposed to just making more mistakes – then it raises the question of whether or not there was a conspiracy to commit fraud. Were any of this to be true it would worsen the already dubious condition of many banks’ balance sheets.

What makes this even more interesting that it was just yesterday that analysts were cooing over the better-than-expected earnings J.P. Morgan. This was one of the reasons the press gave for explaining the very odd fact that the Dow closed at or over 11,000 for a fourth straight day. It is worth noting that the Dow has risen more than 1,300 points since July 2, presumably on the basis of all the good economic news of late. Could someone please remind what that news was? Anyone? Bueller?

As long-time readers know I view the stock market as much more of a leading psychological indicator than an economic one. I am still hoping for evidence that will convince me otherwise.

THEN AGAIN IT COULD JUST BE A COINCIDENCE: Bill McBride, who writes Calculated Risk, says: The banks are still catching up on the earlier foreclosure moratoriums – and extended periods for trial modifications.  This surge in repossessions was expected and I think unrelated to “foreclosure-gate”

 

A guide for the perplexed to the economic mess

The problem with the economy is clear, but it’s been obfuscated out of most people’s minds. So, to put it simply: Financial institutions loaned out a huge amount of money against assets that are now worth far less and whose value is still falling. Somehow, someway, the difference between these two numbers has to reconciled. Simply put, money loaned (X) – current value of assets (Y) = amount of debt to be accounted for (Z). Solve the equation and you know exactly how solvent our economy is.

This week we have found out that Y equals even less of X than previously thought – and the previously thought numbers were already pretty bad. That is because banks screwed up the paperwork so badly they are having major problems proving they do indeed have a legal right to the homes they gave mortgages on. Short form: The banks effectively gave that money away. So the debit side of their ledgers just got a whole lot redder and Z just got a whole lot larger.

Bank_Failure_700_Billion Now Z was bad before this latest fiasco was discovered. How bad? Bad enough the banks and the government have gone out of their way to make to figure out what Z is worth. My theory is they believe – perhaps reasonably – disclosing Z will cause the world’s economy to go into freefall. Unfortunately Z is not going away. So because these groups cannot change the value of X and the value of Y keeps getting smaller, they have resorted to fiddling with the – and the =.

First, the government tried to purchase mortgage debt(X) from the banks. The problem with this is that selling X would mean declaring its value, i.e. providing a real number for Y. This would mean admitting what everyone knows – that a number of banks have debts well in excess of their assets.

Because this didn’t work, the government tried to alter the equation’s minus sign by giving banks enough funds to be able to withstand solving for Y. Under this plan we get X + $100s of billion – Y = Z. Given how hesitant banks were to take toxic asset relief payments (or whatever they’re calling it now) it is reasonable to conclude that Y = way more than hundreds of billions.

But wait, you say! Many of these financial institutions have already repaid the bailout money! Yes, that is true. However keep in mind, they repaid it with money borrowed from the government. This is robbing Peter to pay Paul as imagined by M.C. Escher. Those staircases are never going to meet up but it allows both the banks and the government to say that they do while hoping that no one reads the fine print.

So being unable to either 1) increase X enough to do any good or 2) stop the actual value of Y from declining, the government tried letting financial institutions play lets pretend with the book value of Y. Recent changes in accounting rules let institutions can the value of a property at what they think it would go for in an “orderly” sale, as opposed to a forced or distressed one. Or, to quote the head of the central bank of Wonderland: “When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean—neither more nor less.”

What all those measures did was to allow the economy to continue to operate because we all pretended the problem would somehow go away. This is an attempt to put off the day of reconciliation until some time in the far distant future when someone will have figured out a solution that won’t hurt. However, this is impossible. The solution will hurt, and it will hurt a lot.

All talk of growing our way out of the recession is absurd. It is based on the belief that we can continue to increase the size of the economy as was done earlier in this decade. Let’s make one thing clear: The last decade’s worth of growth was funded by loans against assets that were never worth those loans in the first place. Trying to go back to that means continuing to believe in the fiction that it was ever sustainable in the first place.

The healthy economy of our future won’t resemble this in anyway. We will have to accept far more modest growth and lower our expectations about always having the newest stuff. We may have to pay our farm workers enough that those jobs, and others like them, because financially appealing to American citizens. That will mean paying a lot more for food and other things.The US has to become home to manufacturing again. This will mean enacting things – like tariffs – that a lot of powerful corporations don’t want. NAFTA and other free trade agreements are going to have to change drastically.

Of course, we don’t have to do these things. Regardless of what we do, though, the economic equation will be resolved and that debt will somehow be accounted for.

But hey, the Dow’s over 11K so no worries, right?

Who could possibly have seen the banking disaster coming?

What was the theory behind the Glass-Steagall Act? Foremost, it was meant to restore a certain sobriety to American finance. In the 1920s, the banker had gone from a person of sober rectitude to a huckster who encouraged people to gamble on risky stocks and bonds. As [chief congressional counsel Ferdinand] Pecora noted, small investors identified banks with security, so that National City salesmen “came to them clothed with all the authority and prestige of the magic name ‘National City.’” It was also argued that the union of deposit and securities banking created potential conflicts of interest. Banks could take bad loans, repackage them as bonds, and fob them off on investors as National City had done with Latin American loans. They could even lend the investors money to buy the bonds. A final problem with the banks’ brokerage affiliates was that they forced the Federal Reserve System to stand behind both depositors and speculators. If a securities bank failed, the Fed might need to rescue it to protect the parent bank. In other words, the government might have to protect speculators to save depositors.

Ron Chernow, The House of Morgan, 1990, pg. 375. (Emphasis added)

 

The repeal of Glass-Steagall was passed by Congress and signed into law by President Clinton in 1999.

The arguments made to repeal the act were primarily

  1. Depository institutions will now operate in “deregulated” financial markets in which distinctions between loans, securities, and deposits are not well drawn. They are losing market shares to securities firms that are not so strictly regulated, and to foreign financial institutions operating without much restriction from the Act.
  2. Conflicts of interest can be prevented by enforcing legislation against them, and by separating the lending and credit functions through forming distinctly separate subsidiaries of financial firms.
  3. The securities activities that depository institutions are seeking are both low-risk by their very nature, and would reduce the total risk of organizations offering them – by diversification.
  4. In much of the rest of the world, depository institutions operate simultaneously and successfully in both banking and securities markets. Lessons learned from their experience can be applied to our national financial structure and regulation

Emphasis added

HOORAY? Sub-prime mortgages “back to pre-crisis levels”

The Fed says sub-prime mortgages again make up more than 20% of the nation’s outstanding mortgages.

After plummeting in early 2008, the share of borrowers with FICO credit scores lower than 660 has returned to just higher than 20 percent, the same share as when subprime securitization peaked in 2006.

Once upon a time this number was a bad thing because all those loans were held by private institutions many of which basically collapsed when it turned out people couldn’t pay them off.

Today it is a good thing because Government-backed agencies Fannie Mae, Freddie Mac and Ginnie Mae "are providing unprecedented support to the housing market — owning or guaranteeing almost 95% of the new residential mortgage lending." So all is jake now that you, me and every other US citizen are guaranteeing these turkeys.

The reason for this rebound is not that due to any increase in the financial stability of people with lousy credit scores. No, it’s because the Federal Housing Authority seems determined to recreate the housing bubble “by providing vital insurance that enables borrowers to qualify for loans with as little as 3.5% down.

The FHA is, of course, a picture of fiscal health. The agency recently admitted that “a soon-to-be-released audit will show that its reserve fund has fallen below the level required by law, meaning it will not be enough to cover 2% of all outstanding FHA mortgages.

One solution proposed to get the agency’s reserves back up to what the law requires:  Raise the minimum down payment on FHA loans to 5%.

But – reports the LA Times — “new FHA Commissioner David H. Stevens said such a move could threaten the nascent housing recovery. A person looking to buy a $300,000 house, for instance, would have to raise an additional $4,500 for the down payment.”

If you can’t afford another $4.5K for the down payment, you probably can’t afford $300K either.

Says who?

The FHA itself. That’s because – just like in the last housing bubble – the lenders don’t really have a clue as to how much the borrowers can repay. We know this because the FHA has admitted it really hasn’t done much to screen the lenders for things like basic competence.

According to a report by the FHA inspector general: “The agency approved nearly 3,300 lender applications in fiscal 2008, more than triple the year before. But the number of workers evaluating applications remained the same. In a review of 22 approved applications, the audit found that only one contained all the necessary documents.

History repeats itself first as tragedy then as farce, someone once said. Unfortunately the farce doesn’t leave you any better off than the tragedy.

By the time this is all done the economy will look like it’s been hit by a typhoon of monkeys.

BON TON ROULEZ!!!

Bank fails after taking “Jesus saves” literally

JC savesRiverview Community Bank of Ostego, MN, whose founder said God told him that He “would take care of the bottom line,” was closed by the FDIC last Friday.

Chuck Ripka, one of the bank’s founders, once told the Star Tribune that God spoke to him and said, "Chuck, if you pastor the bank, I’ll take care of the bottom line." Ripka and his staff would pray with customers in the bank’s Otsego branch and even at the drive-up window. (A story I once heard about not mixing money lenders and temples suddenly comes to mind.)

Seems the Good Lord didn’t tip Mr. Ripka to the fact that home prices do not always head toward Heaven. The bank was an aggressive real estate lender and at one point had the fourth-highest concentration of real estate loans-to-capital of any community bank in the Minnesota. Riverview’s mistakes weren’t limited to bad loans it seems. Earlier this month it had reached an agreement with the Fed to cease paying dividends and correct violations of law spelled out in a May letter from the Fed. The order didn’t identify what laws were broken.

 

(And speaking of banks in need of divine intercession, check out: Citigroup’s "Hail Mary Pass": How To Know Citigroup Is In Serious Trouble)