Monday, March 23, 2009

Crash Test Dummies

I spent the better part of my undergraduate career in a restaurant named Rudy’s. Okay, it wasn’t a restaurant, exactly, although I think they had hamburgers. It was an upscale tavern.

Okay, it wasn’t that either, but we solved many of the world’s problems there, fueled by $4 pitchers. Lately I’ve been thinking about a picture on the Rudy’s wall, one I sat beneath countless times.

Prelapsarian New Haven

This football game in the photo is a famous one. With 70,000 fedora-clad people watching in a sold-out Yale Bowl, Albie Booth, an unknown Yale sophomore, came off the bench to lead Yale to a come-from-behind 21-13 victory over a heavily favored Army squad. Newsreels of the day reported the game with the caption, “Booth 21, Army 13.”

I had the son of a friend of mine who’s currently an undergrad go snap this for me. I called the proprietor and asked him if he could do it, but that never happened, and I frankly would have been disappointed if service at Rudy’s had improved to the point where this was possible. So thanks, Phil, for pinch hitting.

I can still see the remnants of my initials, incidentally, on the wall beneath the corner of the second picture from the right (only the top half of the “J” is visible). It was in the booth below that we penned the song “P is for the P in Pierson College,” a fact meaningful to you if you are one of a few thousand people, and completely without meaning otherwise. I digress.

Here’s what I always noticed about this picture. In the lower right hand corner of the photo is the date of the game: October 26th, 1929, forty-eight hours before the crash. I would stare at that photo and think, if only I could lean inside that photo and scream sell. If only they knew what we know now.

Hmm, scratch that last thought, because here we are again, in another doozy of a crisis. I wonder, what picture will students of the future stare at from our era? Will it be something like this?

Or this?

Who knows? But it begs the question,

How Did We Get Here?

This is the only time I can remember when the “world to end tomorrow” crowd actually got it right. Normally, you can make a very nice living betting against the guns ‘n gold crowd. Y2K anyone?

Not this time. While we’re not heading all the way back to the 1930s, this is still bad, bad stuff. And yet, there’s a lot of confusion around what happened, exactly. Oh, we all know bits and pieces, but would you be comfortable explaining it to someone? So, I’m going to humbly attempt to distill down my own take on this into a couple of pages. If you feel you have total clarity, feel free to skip ahead.
First, the 20,000 foot view:
We were too leveraged.

Okay, simple enough. Now the 10,000 foot view:

People borrowed money irresponsibly.
Institutions lent money irresponsibly.

The first part is easy enough. Everyone had too much debt on their personal balance sheets. More specifically, they got into mortgages they couldn’t afford when the economy went south. Yes, there was a lot of credit card debt, etc., but the real problem was mortgages. And I say “people,” because while corporations got fairly levered, too, they were not what got our whole economy into trouble.

One problem I have is that the chattering classes don’t assign any of the blame to irresponsible borrowers. Nobody forced anyone to take on huge mortgages and not even read the contracts. The notion of bailing these folks out steams me. And I have always found the phrase “predatory lending” faintly ridiculous.

The second part of the problem, irresponsible lenders, takes a little more ink. It falls into two categories:
1. Government-created problems
2. Privately created problems
That the government bears a huge part of the responsibility for what’s going on is quite clear. Since the 70s, the federal government has pursued policies that pushed homeownership into the hands of those who couldn’t afford it. Fannie, Freddie used implicit government guarantees to make mortgages cheaper, and they financed billions of subprime mortgages. The Community Reinvestment Act and its enforcers like ACORN and the Justice Department were used to browbeat and threaten lenders into making subprime loans. So they did, lest they be picketed, or worse, hauled into court.
But that doesn’t mean that the private sector was blameless. Some very creative mechanisms were invented to feed the ever-growing lending machine. To understand this, let’s go back a bit and recall the Bailey Brothers Building & Loan model from It’s a Wonderful Life. Local citizens deposit money in the bank and the bank loaned this money out in the form of home mortgages to other local citizens.

“You're thinking of this place all wrong, as if I had the money back in a safe. Your money’s not here. Your money is in Joe's house, that's right next to yours, and in the Kennedy house and Mrs. Macklin's house and a hundred others. You're loaning them the money to build and they'll pay it back!”

This model had the great advantage of “knowing the customer.” George Bailey knew everyone in town and could make reasonable credit judgments. Further, if his judgment was wrong, he paid the price. No subprime here.

On the other hand, Bailey Savings & Loan had one big disadvantage: a huge mismatch between assets and liabilities. Liabilities (deposits) were short term, while assets (mortgages) were long term. This left George prone to ruinous bank runs, just like in the movie.

Fast forward to the late 1970s. Lew Ranieri, an overweight, chain smoking man without a college degree, had a clever idea. He thought, why not buy up lots of these mortgages from all the Bailey Savings & Loans and package them together, and then sell the package? This would make for an interesting, bond-like investment for lots of institutions, plus it would solve the mismatch problem for the S&Ls by letting them just sell the mortgages to someone else. Brilliant. Ranieri helped Salomon Brothers, his employer, climb to the pinnacle of Wall Street. I was there at the time. We used to gaze over to the other side of the trading floor and watch Ranieri’s group consume prodigious amounts of food at lunch. Hey, they were making the firm tons of money; a little spilled marinara on their ties could be overlooked.

The market boomed as mortgages became a key part of any institutional portfolio. But the seeds of a new problem were being planted: while the mismatch issue was solved, mortgage originators had less incentive to “know their customers,” since they were just passing the mortgages upstream. As time went on, it wasn’t even S&Ls that were doing the mortgage originating anymore, it was firms like Countrywide Credit, who were simply paid a commission for any loan they could originate.
Wall Street was the next stop for the loans as bankers would gather them up and package them. Shouldn’t Wall Street care about crappy loans? Yes, and they did, but they thought they had a clever way to deal with them. More on that in a moment.

The packages they created were often in the form of CDOs, which prioritized incoming mortgage payments.

Securitization Done Right

In the picture above, claims on the loan portfolio are prioritized. Cash, as it comes in, goes first to the holders of the triple-As and last to the people at the bottom. This structure is sometimes known as a “waterfall”. On the other hand, defaults would start at the bottom and work their way up. This is a totally sound structure where defaults have to reach absurd levels to affect the triple-A tranche.

But then, Wall Street, along with the ratings agencies, took a horrible turn. Mind you, few understood that it was a tragic mistake, so it’s not like there was malicious intent. Nonetheless, here’s what happened:
Securitization Done Wrong

Someone got the bright idea to take a low-rated slice out of the first “waterfall” and make a whole other waterfall, often called CDO2. This waterfall was then given its own cascading series of ratings, including a big slug of triple-A. How? It was surmised that even if the tranche was filled with deadbeats, someone would pay their mortgage. Statistically, it was thought that in fact most would, and therefore the triple-A investors would be safe. This is where the ratings agencies made their big – colossal – mistake.

The problem was that no one had modeled a meaningful decline in American home prices because the historical data didn’t show that ever happening. It happened in the 30s, of course, but no one had the exact data, so, where the modelers were concerned, it was like it never happened at all. So, as prices actually did start to decline a couple of years ago, defaults started flowing up the left-hand waterfall and sure enough, the B-tranches were taken out almost all at once. Of course, that means the second waterfall was also taken out all at once. Triple-A had become meaningless. It was all junk.

Another problem has its roots in the way Wall Street pays itself, which is generally a smallish annual salary and a large bonus based on each year’s performance. (This is something I have written about before.) As a result, even if someone had realized how dangerous a game they were playing, they wouldn’t have had any incentive to care. The game became so profitable that you only had to play it for a few years to make a pile of money. If it blew up in year four or five, it was fun while it lasted. It’s not like you had skin in the game.

Coming up with a comp structure that corrects these flaws is no easy task, but clearly pay has to be pegged to performance over a longer time frame. I know that various banks are thinking through this right now.

And there you have it - the genesis of almost all the “toxic assets” you hear about. It’s what has made our big banks insolvent, because they own tons of this stuff (as it apparently never got resold). Understand the last couple of paragraphs, and you know most of what there is to know. Sure, there were other issues like credit default swaps, which is what got AIG in trouble, but CDOs are at the epicenter of this crisis.

Back to the irresponsible lending part. You can see, I’m sure, that once you had this clever machine that created triple-A out of thin air, all you wanted to do was feed it. It didn’t matter what you fed it with. The mortgage originators, happy to oblige, eliminated any credit standards for loan applicants and even began lending 100% against home values (side note to all of us: should we ever see this happen again in our lifetimes, sell, Mortimer, sell).

This also became fertile ground for scam artists who would find crooked appraisers to value a home at, say, $1.5 million instead of $1 million. The Countrywides had no real incentive to look closely into this, and by the time it got to Wall Street it was too late.

So, what are the lessons in this? Can we actually get smarter, or are disasters like this in our DNA? Ideally, we’ve learned the following:

1. The government should stay clear of trying to influence markets, other than putting in place broad, commonsense regulations such as credit limits. Sadly, I don’t see this happening. In fact, things seem to be going quite the opposite. (So distressing is the current political climate that I haven’t yet had the mental strength to comment – but that will come.)
2. No one should borrow too much. Okay, that’s a no-brainer. It’s also a no-brainer that people will just as soon as credit becomes easy.
3. We should avoid creating (or buying) overly complex instruments. In the end, not even Wall Street CEOs understood what some of the mad scientists were creating. I doubt we’ll pay attention to this lesson for more than another three years or so.

The inescapable conclusion, for me, is that a meltdown every generation or two is inevitable. It is quite literally in our DNA, because its roots are in our natural instincts for fear and greed (I’d throw in sloth, too). And remember, the next crisis will not look like this one, just like this one doesn’t look exactly like 1929. It will take on a different form, just different enough for people to convince themselves the threat is not real.

For those tempted to think this is some sort of fatal flaw in capitalism, and that some sort of Euro-socialism is the answer, think again. Socialist countries suffer economic downturns just like we do, and in the good times they, well, suck at wealth creation. Socialism is all the downside with little of the upside. Unfortunately, this dynamic openly pleases the statists among us.