The Trillion Dollar Meltdown

Time for another book report. I just finished this book yesterday. It is another very timely book explaining the financial debacle we are now experiencing.

Charles R. Morris, “The Trillion Dollar Meltdown” (Easy Money, High Rollers, and the Great Credit Crash), Public Affairs., Co., 2008

Morris claims we are living in the most reckless financial environment in recent history. Arcane credit derivative bets are now well into the tens of trillions. The astronomical leverage at major banks and their hedge fund and private equity clients virtually guarantees massive disruption in global markets. A quarter century of free-market zealotry that extolled asset stripping, abusive lending, 100:1 leverage practices, and hedge fund secrecy will go down in flames with it.

Pg. xii: Subprime related losses will probably amount to $500 billion. But it is just the first boulder in an avalanche of asset write-downs that will rattle on through much of 2008. An overhang of subprime-like assets, at least as large, is sitting in corporate debt, commercial mortgages, credit cards, and other portfolios. Even municipal bonds may be at risk. The entire bill will be at least $1 trillion. How we got to such a place is the purpose of this book.

Pg. 39: Collateralized Mortgage Obligations (CMO) were invented in 1983 by Larry Fink and a First Boston team on behalf of Freddie Mac. Mortgages were transferred to a trust and then sliced, or tranched, horizontally into three segments, with different bonds for each segment. The trick was that the top-tier bonds, which represented, say, 70% of the value sold, had the first claim on all cash flows. Since it is inconceivable that 30% of a normal mortgage portfolio can default, top-tier bonds got triple-A, super safe ratings and paid commensurately low yields. The second tranche typically included the next 20% of mortgages and sold at a somewhat higher yield, while the third tranche, covering the last 10%, was the first to absorb all losses. But since it also absorbed all the yield savings from the top-rated bonds, it could pay very attractive junk-bond-type yields. CMOs, in short, looked and paid just like bonds and offered yield choices to satisfy appetites across the entire risk spectrum.

Pg. 40: Within a few years of the advent of the CMO, the industry decomposed into highly focused sub-sectors. Mortgage brokers solicited and screened applicants. Thinly capitalized mortgage banks bid for the loans and held them until they had enough to support a CMO. Investment banks designed and marketed the CMO bonds. Servicing specialists managed collections and defaults. Since CMOs were so much more attractive to investors, the interest premium, or spread, over Treasuries steadily dropped. It is a classic illustration of the social contribution of financial innovation. But then the complexity of the instruments spiraled into absurdity. By the 1990s CMO shops spewed out 125-tranche instruments that no one could possibly understand.

Pg. 54: Three dangerous trends:
*The relentless deregulation drive that started during the Reagan administration steadily shifted lending activities to the purview of non-regulated entities, until by 2006, only about a quarter of all lending occurred in regulated sectors, down from about 80% twenty years before.

* A worsening of the “Agency” problem—or the problem of ensuring that an employee, a contractor, or a company performing a service doesn’t act against your interest. For example, a young trader destroyed Barings Bank in 1997 by taking exorbitant trading risks. Highly compensated traders playing with the house’s money are an extreme, and well-known, case of the Agency problem, so most trading houses have developed elaborate risk control procedures to protect themselves. Barings didn’t, and paid for it. So has the bank in France this past year. Now the people approving and giving out mortgages sell them off quickly so have no need to worry if they will default.

* The increased dominance of investment decisions by mathematical constructs. Large securities portfolios usually do behave more or less as the mathematics suggest but the analogies break down in times of stress.

All three of these above trends—the shift of financial transactions to unregulated markets, the steady worsening of the Agency problem, and the pretense that all of finance can be mathematized—flowed together to create the great credit bubble of the 2000s.

Pg. 60: In the mid-1990s banks embraced securitization. Instead of holding their commercial mortgages, corporate loans, high-yield takeover loans, emerging market loans, and such on their books, the way bankers always had done, they began to package them up as collateralized loan obligations (CLOs) or collateralized debt obligations (CDOs) and sell them to outside investors. They could still collect hefty fees while encumbering little if any of their capital. Lending, in other words, was becoming costless. Now banks gave out home equity loans to strapped homeowners and high-rate credit cards for insolvent consumers. You logged in the loans, collected your fees, and sold them off to yield-hungry investors. The investors were “insured.” Your fees were real money. The loans might even be paid off.

Pg. 63: Greenspan’s insistence on focusing only on consumer price inflation, while ignoring signs of rampant inflation in the price of assets, especially houses and bonds of all kinds, remains highly controversial. Academics can adduce technical reasons why central banks should not concern themselves with asset prices. But common sense demands some intervention when prices of a major asset class are soaring beyond all reason. In 2004, for example, the Economist magazine worried that “the global financial system...has become a giant money press as America’s easy-money policy has spilled beyond its borders...This gush of global liquidity has not pushed up inflation. Instead, it has flowed into share prices and houses around the world, inflating a series of asset-price bubbles.” There is also the Greenspan Put: No matter what goes wrong, the Fed will rescue you by creating enough cheap money to buy you out of your troubles. But there are practical limits to how far the Fed can go. Only one Fed chairman presided over a longer period of negative interest rates than Greenspan did. That was Arthur Burns, who set the dubious record of thirty-seven months during the Nixon-Ford-Carter years of 1974-77. But we know how that story ended. It took Paul Volcker, a nasty recession, and a decade of very high interest rates to repair the damage.

Pg. 65: The Greatest Real Estate Bubble in World History. From 2000 until mid-2005 America experienced a housing boom—part of a global real estate bubble that has been pronounced the greatest in history. The market value of homes grew by more than 50%, and there was a frenzy of new construction. Merrill Lynch estimated that about half of all American GDP growth in the first half of 2005 was housing-related, either directly through home-building and housing-related purchases, or indirectly, by spending refinancing cash flows. More than half of all new private-sector jobs since 2001 were in housing related activities.

Pg. 67: The 2000s real estate bubble may be one of those rare beasts conjured into the world solely by financiers, which is confirmed by the fact that housing bubbles also occurred in the UK, Australia, Spain, and other countries where residential lending became unusually loose.

Pg. 68: By 2005, 40% of all home purchases were either for investment or for second homes. (Experts believe that a large share of the “second homes” actually are speculations for resale; lenders don’t review vacation-home purchases as closely as investment properties.) As always, Greenspan cheered it on. In 2004, when families had a historic chance to lock in long-term fixed-rate mortgages at only 5.5%, Greenspan said they were losing “tens of thousands of dollars” by not grabbing one-year ARMS. In any scrapbook of bad advice from economic gurus, that should be near the top of the list. Note: the author is certainly not a fan of Greenspan’s.

Pg. 92: Bretton Woods II (BWII): The headline argument went like this. A big emerging country like China had no choice but to adopt an export-led growth strategy, for it lacks the basic banking and credit infrastructure required for an internal consumption-led boom. During the long transition to modernity, it would need to keep industrial wages low to dampen inflation and to moderate the internal stampede to industrial cities. Over time, the buildup of export earnings would provide the capital base for its own modern banking system, while also protecting against the kind of currency and bank runs that hit East Asia in 1997 and 1998. In the meantime, its dollar investments would benefit from the world’s deepest, most liquid security and trading markets. The upshot was that for the foreseeable future China, India, the smaller Asian tigers, and the oil exporters would have to absorb dollars. Even if the dollar fell steeply, the broader development gains would be worth it.
Skeptics pointed to worrisome differences. Under the first Bretton Woods, America had all the world’s money, so the periphery countries needed to sign up in order to borrow. Under BW2, the central country is still America, but it is now the world’s biggest borrower and has a weak currency, while it is the periphery countries that have all the money. Events, in any case, are making the BW2 debate academic. The move away from the dollar was already under way by 2006, in almost all surplus countries, and appears to be gathering speed.

Pg. 127: The Great Unwinding: In 2008-2009, $350 billion in subprime and other risky residential mortgages will be reset, many at punishing rates. Defaults will rise sharply. A large number of people, perhaps as many as two million, could lose their home.

House prices will continue to fall. Consensus estimates a for a real decline of 10 percent, but pessimists are expecting at least 30 percent—and pessimists have yet to be wrong in this cycle. Many consumers will be stuck with “upside-down” mortgages—i.e., greater than the market value of their homes.

Consumer spending must fall. Consumer spending jumped from a 1990s average of about 67 percent of GDP to 72 percent of GDP in early 2007. As Martin Feldstein has pointed out, that increase was financed primarily by the withdrawl of $9 trillion in home equity and is no longer sustainable.
Exports will continue to improve and over time should make up for the fall in consumer spending. The shift from a consumer-driven to an export-driven economy should be a major factor in emerging from the recession a couple years from now. But it will be a wrenching shift and will take time.

Pg. 152: Martin Wolf, the economist and commentator for the Financial Times, recently noted that over the very long term, global financial services profits are about twice as high as those in the rest of industry. That runs counter to a fundamental proposition of free-market economics, that profits across enterprises should even out over time. The reason for the permanent advantage of financial services is that they don’t really compete in free markets. They earn high profits because they take big risks, as evidenced by their very high degree of leverage compared to other industries. Although the high profits accrue to managers and shareholders, their losses are usually partly socialized. The question is whether the Country-Wides of the world are risk-taking enterprises or public utilities. You cannot be both.

Pg. 157: Political cycles turn when an extended period of either conservative or liberal hegemony brings the baser, more self-seeking, or barmiest elements to the fore. The market and regulatory reforms introduced by economic and monetary conservatives in the 1980s made a major contribution to the recovery of American competitiveness and economic energy in the 1980s and 1990s. But as the more unsavory impulses in the conservative understanding have asserted themselves, the country has been brought to the brink of financial, economic, and in politics, moral disaster. All the signs are that we are on the cusp of a turning of the cycle, much like that in 1980.

Pg. 161: The American regulatory scheme is based on the insight that government can best support financial markets by ensuring that investors get accurate information. To manage the massive volume of American security issuance, the designers constructed a system that operates with a relatively small central staff, relying on the integrity of the accounting profession, the securities bar, and private rating agencies. After a quarter-century of anti-regulatory zealotry, however, and a parade of fiascos from the S&L crash through the Enrons and WorldComs, and now the CDO mess, the credibility of that system, and with it the attractiveness of American markets, is at risk.