with Gerard J. Senick
“These findings are deeply troubling. They show a Wall Street culture that, while it may once have focused on serving clients and promoting commerce, is now all too often simply self-serving. The ultimate harm here is not just to clients poorly served by their investment bank, it’s to all of us. The toxic mortgages and related instruments that these firms injected into our financial system have done incalculable harm to people who had never heard of a mortgage-backed security or a CDO, and who have no defenses against the harm such exotic Wall Street creations can cause.”
— Opening statement by Senator Carl Levin at the U.S. Senate Permanent Subcommittee on Investigations Hearing, 27 April 2010
A Rising Tide
Since 2006, the financial tsunami brought on by a surge of Sub-Prime Mortgages, which flowed into Asset-Backed Securities (ABSs) and Collateralized Debt Obligations (CDOs), has turned into toxic assets, wreaked havoc on the economy, and obliterated the life savings of many American families. These families trustingly had made the “mistake” of holding the major share of their wealth as equity in their family homes. Just as house prices have hit bottom and have begun to show signs of recovery, we find evidence that a second financial tsunami may hit in 2011. This aftershock, brought on by the hollowing out of different classes of mortgage instruments that previously were not at risk, may produce a wave — a bursting financial bubble — that many researchers expect to explode more than the first. However, the saving grace within this second mortgage tsunami lies in the expectation that it will not materialize as suddenly as the first, thus leaving us with some time to find ways to allay its effects. However, even if Congress, Wall Street, and Main Street do act in a timely manner, real-estate prices still may fall once again in 2012 and produce after-effects that last until 2015.
In this series, we will rummage through data and charts provided by the U.S. government and the financial markets of the private sector as well as evaluate the analyses and forecasts produced by professionals working in the trenches of the mortgage and securities markets. However, we will avoid the “Chicken Little” approach of screaming that the sky is falling — again. Rather, we will lay out the evidence of this case in a manner that allows our readers to draw their own conclusions after looking at the facts in the harsh, cold light of forensic economic study.
“Been Down So Long, It Looks Like Up to Me!” (Quote from the book of the same name by Richard Farina, Random House, 1966)
After sinking under the weight of toxic assets, the mortgage market presumably has bottomed out. The wave of Subprime Mortgages that were absorbed by unregulated Hedge Funds has faded into the past for many Americans. Nevertheless, the real-estate market and banking industry keep reeling from the aftershocks. The Senate’s Permanent Committee for Investigations continues to dig through the muck that led to this calamity in the hope that Congress will pass new and renewed legislation to prevent our economic fabric from unraveling again.
However, we have heard little about the second wave of the housing-related economic crisis that many researchers and consultants expect to manifest itself fully in late 2011. As painful as the anticipation of another economic downturn is, the undercurrent for this housing aftershock — a second mortgage tsunami — already has taken hold. The only positive side of the forthcoming chain of events will be the lack of suddenness that caught the nation off guard last time. The negatives ride on the probability that the next wave will linger through 2015.
Many respected researchers and organizations have compiled and published data and warnings as to why and when we may face another mortgage tsunami. The notables include economist Robert J. Shiller of Princeton University, Lawler Economic and Housing Consulting, Amherst Securities, the U.S. Federal Reserve Bank, U.S. Bureau of Labor Statistics, HUD, FHA, Deutsche Bank, Wells Fargo, Citigroup, Mortgage Bankers Association, National Association of Realtors, Goldman Sachs, the International Monetary Fund, Credit Suisse, RealtyTrac, Mark Hanson Advisors, LPS Applied Analytics, Haver Analytics, HSH Associates, Ned Davis Research, First American CoreLogic, Field Check Group, Freddie Mac PMMS, Barclay’s Capital, GMO LLC, Moody’s, Standard and Poor’s, and T2 Partners LLC, among others.
We pay special attention to T2 Partners LLC, of which Investment Fund Managers Whitney Tilson and Glenn Tongue are the two Ts. (We suggest exploring their Web, where Tilson publishes his recommended reading list, notes from the annual meetings of Warren Buffet’s Berkshire Hathaway and Charlie Munger’s Wesco holding companies, and other items of interest: www.t2partnersllc.com). Many of us became aware of Tilson and Tongue’s forecast of an impending second mortgage crisis on the 60 Minutes segment entitled “Where’s the Bottom?” on 14 December 2008 (CBS-TV, produced by David Gelber and Joel Bach). We refer our readers to Mr. Tilson’s lengthy but excellent PowerPoint presentation “An Overview of the Housing Market and Economic Crisis — and Why There Is More Pain to Come,” for which the latest version (currently 1 February 2010) is regularly updated at www.valueinvestingcongress.com. Tilson gathered salient points, charts, and graphs for his presentation. Therefore, in our column, we will parallel his PowerPoint sequence for the benefit of our readers who may wish to dig more deeply. In addition, for those interested in a lively read, we recommend Tilson and Tongue’s book “More Mortgage Meltdown: Six Ways to Profit in These Bad Times” (Wiley, 2009).
Throughout the second half of the 20th Century, real home prices (house values adjusted for inflation) grew slowly and steadily. Following an upward jump at the close of the Korean Conflict, home prices increased at a fifty-year average of four to five percent per year, a rate that slightly exceeded inflation. However, the real-estate market began to ride the roller coaster, with its subsequent ups and downs, on three major occasions: during the period of Stagflation (high unemployment coupled with high inflation) around 1980, the end of the Cold War in 1989, and the collapse of the Internet Bubble in late 1999.
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During the Internet (aka Dot.com) Bubble and afterward, real home prices continued to escalate until 2006, almost doubling during that eight-year period. Increasing market demand drove this rapid rise in real-estate prices. Consumers demanded more and more housing because of an easy mortgage market. This resulted in an increase in borrowing power that outpaced the rise of consumer income. Lenders began to allow much higher debt-to-income ratios and approved mortgages that included features such as interest only, no money down, and low — or no — documentation. From January 2004 through January 2006, market prices exploded upward. However, during the following year and a half, prices hovered at a high plateau, bobbing like the stern of the Titanic, before finally sinking in mid-2007. Prolonged low interest rates in 2004, accompanied by a tripling of borrowing power as a multiple of household income over a six-year time period, further fed the real-estate orgy.
Where is the money in real estate? To put it simply, one-third of homes are 100 percent owner equity (though the current trend of marketing reverse mortgages to the elderly has begun to erode this condition). How about the remainder of homes in America today? On average, home “owners” only hold 16 percent of the equity in their domiciles. This erosion of equity position in the one investment, which traditionally has represented the American family’s greatest depository of savings, has occurred because of the escalation of our borrowing against home equity. This escalation increased rapidly during the late 1990s and through the first six years of the new millennium. The result: between 1945 and the third quarter of 2009, homeowner equity as a percentage of home value dropped by half.
As increased borrowing power and other factors pushed home prices higher and higher while incomes grew slowly or stagnated, housing became more unaffordable in many local markets of the country. Where a fifteen-year fixed-rate mortgage once had served as the standard, even the increasingly popular thirty-year mortgage became unattainable to an ever-increasing number of potential home-buyers.
Today, real-estate brokers, appraisers, mortgage companies, and banks only earn money when properties change hands. Therefore, in order to serve the growing market of would-be home buyers, lenders developed a variety of more “exotic” instruments to facilitate the purchase of homes. As a result, mortgage-lending standards declined steadily during the years of the Bush Administration. All the while, the combination of the ratio of mortgage loan value to home value increased during this period as the offer of limited documentation and 100 percent financed mortgages escalated. (Note: a mortgage loan value to home value that is greater than 1.0, implies that a mortgage is “underwater.”)
Making Sausage
Why would conservative lenders ride this surge of risky loans? The answer lies in the fact that mortgage-market customs had changed over the preceding decades. Mortgage-makers no longer held the notes themselves for the duration of the term. Rather, the custom turned to a fee-based system in which lenders made their money upfront through origination fees and quickly sold the approved mortgages to the wider investment community. This structural change in mortgage lending emerged contemporaneously with the development of fewer and fewer transparent packages created by investment bankers on Wall Street. If one thinks of an individual mortgage as a T-bone steak, then imagine cutting that steak into many small pieces, mixing it with other cuts of meat and fillers, grinding it up, and packing all of it into sausage casing to sell. As Econometricians and butchers long have said, “You don’t want to watch how the sausage is made!”
Of course, bubbles of the magnitude of the Mortgage Meltdown of 2006 and the one predicted for 2011 do not happen all by themselves. They happen because of yield-seeking institutional investors who did not ask enough questions within the financial sector. The other contributors to the Bubble include politicians and “free-marketeer” regulators (who often surf the Web for porn at the office rather than doing their jobs), the acceptability and availability of high debt loads in our consumer culture, a multitude of financial lemmings seeking to “flip that house,” and low interest rates that are attractive to the public at large.
If one takes the time to read the first four chapters of Burton Malkiel’s A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (W.W. Norton and Company, 2007), s/he quickly realizes that every bursting financial bubble of the past four centuries has been preceded by rapidly rising prices. More precisely, the severity of loss is inversely proportional to the growth rate in home prices. Faster and continuously rising prices minimize the severity of investment loss.
While real-estate prices fell in mid-2007, losses compounded rapidly. When home prices stopped rising and subsequently fell by 40 percent, the five-year cumulative losses for the pool of Sub-Prime Mortgages increased by 52 percent. However, rather than experiencing a sheer drop in value, real-estate losses accumulate over time like a snowball rolling downhill. Much of what has happened already continues to occur in our financial markets. It coincides with the deregulation of the banking industry that began in the early 1980s and ran through the 1990s.
If we compare total debt in America to total financial profits, we find an interesting phenomenon. For the thirty years preceding 1980, profits consistently exceeded total debt by an average of one-half percent. However, this situation reversed itself after 1980. Since that time, total debt has exceeded total profits by the same degree in all but four of the last thirty years. Perhaps this reversal of fortune started the proverbial snowball rolling downhill.
Of course, others might suggest that trading debt for profit has helped the U.S. to grow a highly profitable financial-services sector. As a percentage of total U.S. profits, financial services tripled from 10 percent to 30 percent over the past quarter-century. During this same period, wages and salaries in this sector nearly have doubled, from less than 6 percent to 10 percent of the U.S. total. In summary, this highly profitable growth industry has built upon the issuance of and servicing of consumer debt in the form of credit cards, home-equity lines, and, more recently, doomed-to-fail mortgage-lending.
As Wall Street searched for more, and greater, profitable instruments, investment bankers and security dealers looked for new, steady flows of collateral to back securities. Corporate stocks and bonds formed the staid and routine source of collateral for many funds. Furthermore, Security and Exchange Commission regulations maintained transparency in this arena. However, home-equity assets, owned in part by home buyers and by mortgage-note holders, largely escaped regulation. After all, what could be more secure than real-estate equity tied to home values that had risen steadily for decades?
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Mortgage-backed securities came into being in 1987. What emerged as the new order appears to have germinated at the Wall Street firm of Drexel Burnham Lambert, Inc. Events of the era presented Drexel with the opportunity to create a complex structure of securitization. This was fed by a seemingly bottomless cauldron of what we will call “mortgage meat.” Drexel turned the handle of the grinder. When they did so, equity from an $8 trillion cache of mortgages poured into the cauldron. To continue our “meat” analogy, the industry stuffed the sliced, diced, and ground mortgage meat into sausage skins that it named Asset-Backed Securities (ABSs) and Collateralized Debt Obligations (CDOs). However, the securities industry gradually discovered that the supply of fresh meat to satisfy their demand was not endless. As these lines of securities developed into some of the most profitable on Wall Street, the demand grew for more and more input. In a related note, Drexel Burnham Lambert, Inc. was forced into bankruptcy in 1990. Perhaps the moral of this story is, “Just because you invent something does not necessarily mean that you will continue to prosper.”
As long as these new securities remained profitable, the Street neglected to ask basic questions about their ingredients and how this brand of sausage was made. Rating agencies such as Fitch, Moody’s, and Standard and Poor’s were drawn into “the Jungle” (thank you, Sinclair Lewis) of the packing house. This was done by the addition of residual fees to “monitor” the securities that the agencies rated after these securities entered the market. As home prices seemed to increase steadily, the notion grew that one could write a mortgage to anyone who breathed, whether or not they could produce a down-payment or, for that matter, had any income at all. If a person defaulted on his/her note, the lending community could foreclose, seize the property, and sell it again at a profit. In fact, this might seem preferable because note-holders not only could earn a capital gain from a resale, but mortgage companies and banks could generate additional rounds of fees by reselling the same property over and over again.
However, the game could work only as long as underlying home prices continued to rise, or, at least, until the composition of the derived securities maintained some semblance of quality. Unfortunately, this did not appear to remain the case. The basic instrument that brought mortgages into the speculative investment market came in the form of Residential Mortgage-
Backed Securities (RMBS). A higher-grade RMBS would include the least-risk mortgages and the best underlying real property to which these mortgages have been assigned. If the goal of the RMBS-holder remained one of maximizing the quality and, hence, the value of the RMBS, the security-holder would have the motivation to sell off weak tranches (slices or portions) to a less discriminating “sausage-maker.” A number of RMBS that contained 80% or more high-quality notes might sell off the worst of their lots to someone securitizing a Collateralized Debt Obligation. The resultant CDO may contain 90% or more of the worst of the lots from the source RMBS.
One may ask, “Then how does it work?” In effect, the CDO is created as a container to hold assets. In our case, these assets are mortgages. The value of these mortgages to a CDO rests in the fact that home-buyers make a fixed payment each month. This forms the fixed-income stream for the CDO.
Making a Dagwood Sandwich
Blondie and Dagwood have graced the “funny papers” since 1930. Most readers are familiar with Dagwood’s famous middle-of-the-night, mile-high sandwiches. In viewing the complex bar charts used to describe RMBS and CDOs, it occurred to me (Dr. Sase) that these piles, which are composed of layers and layers of various assets, look like a classic Dagwood sandwich.
Therefore, let us pretend that Dagwood has invited another icon of the comics, Beetle Bailey, his nemesis Sarge, and soldiers Plato, Killer, and Zero to a Super Bowl party at his house. For the main course of the event, Dagwood decides to make one of his famous sandwiches for each of his guests and himself. So, he goes to his local deli counter and buys enough bread, meat, and cheese to feed his hungry guests. The morning of the game, he makes six large sandwiches. However, a half hour before the game starts, Beetle calls and asks if he can bring Garfield the Cat. Obligingly, Dagwood says yes. However, he then realizes that he has used up all of the meat and cheese that he bought to make the six sandwiches.
Not wanting Garfield to go hungry (and given Garfield’s enormous appetite and willingness to eat almost anything), Dagwood takes two additional pieces of bread and begins to pull slices of meat and cheese out of the other sandwiches. To make the sandwich appetizing, Dag extracts thin slices of the best meat and cheese to place at the top of Garfield’s sandwich. However, Dag then resorts to pulling as much of the lowest-grade bologna and processed cheese as he can from the first six sandwiches in order to fill up the one for Garfield. Dagwood now has seven sandwiches. The first six are filled mostly with high-quality deli cuts. These represent high-grade Residential Mortgage-Backed Securities.
The seventh sandwich, which contains mostly lower-grade filler, represents a higher-risk security commonly known as a Mezzanine Collateralized Debt Obligation. The term “Mezzanine” comes from theater seating in the City of Shows (NYC). Traditionally, the mezzanine is the front area of the lowest balcony that contains a large number of mid-grade seats. These definitely are not the worst seats possible, but they are far from the best. In the case of a CDO, the mezzanine exists between the foundation slice of equity at the bottom and the AAA-grade securities at the top. In a way, the tranches of a Mezzanine CDO contains sausage that is ground from other sausage.
Of course, this is a colorful oversimplification. With actual RMBS, a CDO simply obtains an interest in slices of mortgage bundles held by the RMBS. The slices of these bundles generate an income flow from home-buyers through a mortgage intermediary, then through the RBMS to the CDO. As a result, one family’s mortgage may find itself chopped up and distributed to many different security instruments. In his PowerPoint presentation, Whitney Tilson states that, in the securities market, “Loss rates of, say, 20%, in the underlying RMBS can lead to catastrophic losses for a CDO.”
So, where is your original mortgage note? Unless it has remained in the hands of a small local institution that wrote the mortgage, your original signed note may be in storage in a warehouse somewhere, a warehouse that looks like the one in the last scene of Indiana Jones: Raiders of the Lost Ark (Paramount Pictures, 1981). In this scene, a workman pushes a handcart down a long aisle. On the handcart is a sealed box, which contains the precious Ark of the Covenant. As the camera zooms out, the audience is left with the feeling that this treasure is falling into the oblivion of cold storage. According to Consumers Warning Network, half of the original mortgage notes in America have been buried away in warehouses or even tossed into dumpsters (for further explanation, watch their short video Fight Foreclosure: Make Them Produce the Note, youtube.com/watch?v=kswEb-iVsms). As a result, judges handling judicial foreclosures around the country are refusing to take part in this fraudulent process.
What has led this crazed rush of lemmings into the sea? Apparently, the particularly succulent moss that leads the doomed lemming parade has been the compensation earned by Wall Street firms and their top decision-makers, especially in Fixed-Income Divisions. A fixed-income security is an investment that provides income in the form of fixed periodic payments. Given a base of mortgages that produce constant monthly payments from home-buyers, mortgage payments channeled through RBMS and their derivative CDOs theoretically maintain a fixed flow of income throughout the financial system.
Tilson tells us that, out of 52,000 employees of Merrill Lynch, 100 each received at least $1 million in bonuses. On average, these top 100 performers received bonuses of $5 million. Profits not only flowed to the leading brokerage houses: ratings agencies also partook of this windfall business. They did so not only by earning fees for doing the actual ratings of these securities but by receiving additional fees for tracking and monitoring the same securities, which wound their way through the market. Apparently, these arrangements proved profitable enough at Moody’s to cause their own value to escalate steadily from $20.00 to $70 per share in the market.
In closing this month’s offering, let us note that Credit Suisse Group AG has predicted more than a three-fold increase in foreclosures by 31 December 2012. This encompasses more than 6.2 million new foreclosures. Of these new foreclosures, 70% will come from Non-Subprime loans. The simple laws of supply and demand tells us that, without a provocative increase in housing demand, such a glutting of the housing supply at foreclosure prices would savage recovering home prices further to levels lower than we have experienced in the recent market.
Next month, we will explore the background of the U.S. housing market and examine Subprime, Prime, Alt-A (those in between the first two), and Option Adjustable Rate Mortgages. In future columns, we will find that the predicted second, larger real-estate bubble will result, in part, from a surge in delinquencies and foreclosures of the last three types of mortgages. This will occur largely because of the effects of high unemployment, which are accompanied by plummeted homeowner equity caused by the first tsunami.
Carl Levin is Michigan’s Senior Senator in Washington, D.C. Through the bi-partisan U.S. Senate Permanent Subcommittee on Investigations, he has taken up the fight to fix the problems that have run rampant in our financial sector. Senator Levin can be reached at senator_levin@levin.senate.gov. Whether our readers are Democrats or Republicans, we urge them to contact Senator Levin to push Congress to reduce the impact of the coming Second Mortgage Tsunami.
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Dr. John F. Sase of SASE Associates, Economic Consulting and Research, earned his MBA at the University of Detroit and his Ph.D. in Economics at Wayne State University. He is a graduated of the University of Detroit Jesuit High School. Dr. Sase can be reached at (248) 569-5228 and by e-mail at drjohn@saseassociates.com.
Gerard J. Senick is a freelance writer, editor, and musician. He earned his degree in English at the University of Detroit and was a Supervisory Editor at Gale Research Company (now Cengage) for more than 20 years. Currently, he edits books for publication and gives seminars on writing. Mr. Senick can be reached at 313.342.4048 and by e-mail at gary@senick-editing.com.
