Part One
WE ALREADY HAD A 'SUBPRIME' MORTGAGE CRISIS, THIS IS THE SECOND IN A ROW
In his recent op-ed, Paul Krugman wonders aloud about our "Ponzi era", about how we all could have not noticed, basically, about financial services in general. He concludes, in essence, that we lived an era of post hoc, ergo propter hoc, regarding those looking the part in money management. {But read the comments section for the good stuff}
Many others, including the ever-readable Martin Wolf, have looked in detail at how "we" missed it, how the latest junk-credits from Wall Street went undetected until it was too late.
Greenspan himself has indicated that he relied on the collective wisdom of market participants, ending up shocked that they failed to secure the (long-term?) interests of shareholders.
For my own part, I initially underestimated what would become the full scope of the problem. I think it is because I didn't imagine that Green Tree Financial had left the collective conscience.
REMEMBER GREEN TREE FINANCIAL?
Well apparently, not too many people do. I remember it vividly, however.
Did the quantitative people in the departments at the ratings agencies (Moody's, S&P) have more than a degree? Did someone from the "real" credit area take an elevator down to look over the shoulder of their proverbial CDO Queen? Was there a risk-policy committee? God knows, the implication of Green Tree made it to the radar screen of leading economists (and, as best I recall, Greenspan's purview. Update: yes, see here).
There should be more hearings, right?
Anyway, here is the story of Green Tree Financial and the manufactured housing bust.
I've pulled some quotes, that make it rather plain just how much it looks like the very same sub-prime crisis that eventually grew to $700-1,800 billion.
The question becomes, how did we have two sub-prime crises in a row, in rapid succession, even?
A Boom Built Upon Sand, Gone BustFrom 1991 to 1998, annual sales of manufactured homes more than doubled, to 374,000 from 174,000.
One company, one man and one accounting rule drove that growth.
The rule, a rarely used accounting convention called ''gain on sale,'' encouraged Green Tree to make as many loans as possible and allowed it to report more than $2 billion in profits that never existed.In their rush to lend, Green Tree and its rivals made loans to borrowers who had little chance of paying them back. Tens of thousands of those people have already defaulted and have been evicted. Conseco alone has repossessed 25,000 homes so far this year, after a record 28,466 in 2000. By the time the industry's hangover ends later this decade, hundreds of thousands more low-income borrowers will lose their homes. They will wind up with huge debts and ruined credit because their homes are worth far less than what they owe.
Securitization provided Green Tree with ready access to capital from the bond buyers, and that enabled it to finance as many loans as it wanted. At the same time, gain-on-sale accounting allowed Green Tree to record income from every loan that it made.
On April 28, 2000, with the company's shares at $5.63, Mr. Hilbert quit. He received a $72 million severance package, including the right to use Conseco's private jet up to 20 times a year. All told, Mr. Hilbert's pay from 1993 to 2000 was $530 million.
Mr. Coss did not do quite as well. His pay, tied to Green Tree's reported profits, totaled about $200 million from 1993 to 1998, including a $30 million severance package.
More references:
April, 19998:
April, 2000:
[This one reads like a bad omen for the Bank America and Merrill "merger", yes?]
December, 2002:
Showing posts with label Fannie Mae. Show all posts
Showing posts with label Fannie Mae. Show all posts
Friday, December 19, 2008
It Was Not an 'Act of God', Part II
Monday, December 15, 2008
It Was Not an 'Act of God', Part I
All these are false or incomplete:
- - "One is a failure to recognize the unavoidable uncertainty surrounding estimates deep in the tail of distributions based on limited data."
- -Default likelihoods and correlations were "misestimated", leading to a gross 'mispricing of credit risk'.
- -"Another failure is a lack of structural imagination in assessing the likely consequences of contingent events such as a general fall in housing prices."
- - Housing prices were thought to only go up (even in the United States), by any or all of brokers, speculators, buyers, lenders, and regulators.
Also up for batting practice, "we have just seen a black swan", although that one might be a little more complicated.
Franklin Raines, Chairman of Fannie Mae, 1999-2004:Given that there has been relevant experience and data, among the possible implications:
"The company had significant experience during the 1980s and early 1990s with the impact of falling housing prices on the value of mortgages. In the 1980s, the company experienced significant credit losses as a result of the economic meltdown in the oil patch areas of the Southwest. In the early 1990s, the overheated housing markets in California and New England also caused significant losses.
The company also studied the different credit performance characteristics of mortgages with certain features, such as adjustable rates or negative amortization; mortgages with certain underwriting approaches, such as no documentation of assets or income; and mortgages with certain borrower types, such as those with marginal credit or housing speculators. These features create greater credit risk. Furthermore, the layering of more than one of these characteristics on an individual loan greatly magnifies the risk. In many cases, there is no precedent to rely on to calculate the performance of such risk layering."
- Institutional memory is important.
- It is often wise to analogize risk from similar events, rather than discount it.
- Imagination happens to the prepared mind.
Friday, December 12, 2008
Quote for The Day
The latest CDS salvo had me go read Arnold Kling's testimony from earlier this week (previously, I just went on what I heard, what was spoken for the committee).
Rather than more on CDS today, here is some more confirming evidence that I, a complete outsider, have the right read on key issues at the GSEs:
When I was at Freddie Mac, there was hardly any gap between the suits and the geeks. The Foster-Van Order model of mortgage default was ingrained in the corporate culture. The CEO, CFO, and other key executives understood this model and its implication that mortgage defaults would be much higher for mortgages with low down payments. Moreover, the suits bought into the idea of using a stress test to set capital requirements. Using a stress test methodology, in which mortgages are evaluated according to how well they would survive a downturn in house prices, the capital required to back mortgages with low down payments is prohibitively high.
When a new CEO came to Freddie Mac in 2003 (several years after I had left), a gap apparently opened up between the suits and the geeks. Warnings issued by the Chief Risk Officer and others about low down payment mortgages were ignored by the CEO.
An organizational failure requires an organizational re-design. It doesn't require a ... a whole lot of hand wringing about everything else.
Thursday, December 11, 2008
Quote for the Day
No regulation or law forced banks or the GSEs to acquire loans that were so risky they imperiled the safety and soundness of the institutions. The acquisition of such loans was a business judgment made by management and the boards of directors.
- Franklin Raines, former CEO FannieMae, yesterday's testimony
Raines testimony is fascinating. His grasp of the issues seems to far exceed those of his peers at the table.
More to say later on (I'm reviewing data, sorting out Christmas presents, and much else besides!).
Tuesday, December 9, 2008
Fannie Freddie - First Pass
It was demand pull, not supply push.
The creation of slik purses out of sow's ears had created a credit 'mania' on Wall Street, an insatiable demand for 'product', so much so that large brokerage houses felt the need to have their own, captive sub-prime origination units.
There were other factors, but this, more than the others, is explanatory. It explains almost all the pressures created by the demand for volume.
If anything, I'd be looking for evidence that HUD goals raised in the 2005 period and onward, like so much else, followed or abetted the mania, not that they were the cause of it.
Today's hearing details here.
Quote for the Day 2
Arnold Kling, who doesn't believe in securitization does not believe securitization is necessary:
it turns out that when a high-risk loan has been laundered by Wall Street, it can come back into the banking system in the form of a AAA-rated security tranche.
Quote for the Day
"Reality exceeded my imagination." - Daniel Mudd, 2003-2008, FannieMae CEO
***
"For two years, Mr. Mudd operated without a permanent chief risk officer to guard against unhealthy hazards." - New York Times, Oct 5, 2008
Wednesday, November 19, 2008
Diagnosing Freddie and Fannie
FIX THE FORMULA, SAVE THE WORLD
We know that Freddie and Fannie dropped their market share (h/t Krugman) at the time when the worst vintage loans were being originated. Because of Fannie's fancy-accounting penalties and because they did not participate in a lot of the "affordability products" dreamt up, they were not the drivers of the worst excesses of the markets.
Well, despite consistently applied loan standards, it looks like their economic model for underwriting was not designed with the notion that a housing price bubble could develop. Their formula appears to have been tied to house prices, rather than to "economic fundamentals".
If they certainly didn't create "the bubble", they did get pushed around by it, based on my first look at the figures.Why did they, if it wasn't some exceptionally bad credit underwriting standards (the bulk of their credit losses appear to be in one part of the portfolio)? Well, despite consistently applied loan standards, it looks like their economic model for underwriting was not designed with the notion that a housing price bubble could develop and that could be a factor. Their formula appears to have been tied to house prices, rather than to "economic fundamentals".
BUBBLE PROOFING FANNIE MAE
FHFA/OFHEO, their regulator, sets a "conforming loan limit", among a number of other conforming characteristics. This is key to segmenting the market, for policy purposes, I'd suppose. Now, this limit periodically gets adjusted. How? It looks like it is roughly tied to the OFHEO house price index, with various degrees of lags and discretion.
Of course, all lending does not take place at the limit, so to speak. However, the average loan amount, the new business for a given year, tracks that year's loan limit pretty closely. The two are in a ratio of near 2, for the priod over which I can get data.
Chart 1. The progression of Fannie's conforming loan limit and the average loan size, shown as a ratio (green line). In 2006, the limit was raised to $417,000.
How closely did the limit progression track home price rises, during the go-go days? It lags. They were not being super aggressive. Had they followed the price index lock-step, the conforming limit would have risen faster. In fact, before the big step-up in 2006, to $417K, the limit was over $45,804 below where it might have been, if it had been raised lock-step since 1991 with home price increase. $45K is a material 'undershoot'. Today, with a fall in home prices and the emergency measures to raise the cap even more, the difference between the actual and implied has been wiped out and the limit is actually above where it would be under a lock-step price-formula only.
Chart 2: Green line tracks how much home prices are rising faster than the conforming loan limit is rising. Red line tracks cumulative dollar impact implied by the difference.
What if they had used an "economic underwriting formula", one that was based on economy-wide fundamentals, like median or average household income?...it makes a case that it is not to difficult to "fix it", so that today's problems are less likely to recur, and the mission of the two GSE's is not cast aside, unthinkingly.
Well, for one thing, they would have cut themselves out of the marketplace, even more. That may seem trivial, but it's an important consideration, when you think of organization re-deisgn. In a bubble regime, one is intentionally, slowly withdrawing "liquidity", which is something that may be counter-intuitive to an organization whose mandate has always been to provide liquidity.The two charts below show that there was stability in the ratios of the conforming loan limit to either mean or average income, until the mid 2000s, when it rose sharply.
These charts are, of course, bad news, now that we know the outcome of the rise in home prices and how badly this Administration has been in dealing with the aftermath, especially foreclosure mitigation efforts. Between 2001 and 2007, the average Fannie loan size rose 45%, but average household income rose only 16% (by Census Bureau estimates).
Nevertheless, it makes a case that it is not to difficult to "fix it", so that today's problems are less likely to recur, and the mission of the two GSE's is not cast aside, unthinkingly.
Charts 3 & 4: Census data on average and median household income related to OFHEO's conforming loan limit (the conforming loan limit tracks average loan size, i.e. the actual values done by the GSEs, fairly closely). No adjustments are made for changes in such financial variables as inflation or general real-estate affordability factors.
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