What the Hell Happened?

Without detracting from the strengths of either candidate for president (and expecting so little of our current leader), I’m mad as hell at the total failure of our political leadership to answer three fundamental questions:

1. What happened?
2. What’s going on now?
3. What’s to be done?

For those of you who know me by my entertainment career, I may seem a strange source for financial information. But, I was once the CEO of the Global Association of Risk Professionals, and so have a brief history of communicating complex financial transactions to a broader population. Sitting and stewing, I thought, “Hell, I might as well take a crack at it.” What follows is a plain-spoken, but detailed explanation, summed up with bullet points that I encourage anyone to forward to the overpaid speech writers for either campaign who are clearly asleep at their desks. It’s long – please don’t try this on a Blackberry – and I apologize if my attempt to explain this seems like foolish pride.

What Happened?

Rightly or wrongly, and the merits of it deserve to be debated, as American as apple pie and Mothers’ Day is home ownership. And it’s the government’s job to incentivize home ownership. This is done in a number of ways: most states provide home protection against tort or other legal liability – in New Jersey $200,000 of your home cannot be sought if there is a judgment against you, in Texas there is no limit (wonder why Ken Lay bought a $40MM home?); and of course, the big one, tax breaks for interest on mortgage payments. The mortgage interest deduction makes it easier for first time buyers to get their home as the payments in the earlier years will be offset by tax relief. While we claim that this fosters home ownership, what it’s done is foster home indebtedness as the incentive is on the interest portion of the mortgage and not the repayment of principal.

Unique amongst countries in the world, to facilitate this apple pie policy, we have Fannie and Freddie, well, and Ginnie, but we can ignore her as she’s serving the precise purpose for which she was established. Fannie and Freddie make home ownership easier by buying the mortgages from banks, guaranteeing some repayment conditions, packaging them in bundles that have similar risk properties, and then selling those bundles to institutions seeking those risk levels and expected returns. With the mortgage loans off their books and with money in their pockets, banks can make more mortgage loans. Until the bailout, Fannie and Freddy were not explicitly backed by the federal government (technically, they were government-sponsored enterprises), but everyone believed them to be and acted like they were. Their guarantees were thought to be solid and their debt was AAA rated. It was generally assumed that the Feds would come in if required, which is exactly what happened.

These bundles that I just described are mortgage-backed securities. In most countries, as well as in the United States, banks create these products themselves, without the need of a middle man. But Fannie and Freddie’s guarantees of repayment are much better than your average bank’s. Fannie and Freddie’s guarantees turned risky mortgage packages into investment grade obligations. In the US in 2007 there was almost $2 trillion issued in new mortgage-backed securities. Fannie and Freddie issued about two thirds of these securities. And sometimes, two thirds just isn’t enough.

Giant anomalies, neither private nor public, Fannie and Freddie couldn’t get no love. They did themselves some serious damage a few years ago when accounting scandals revealed some major problems in each. They turned on the charm and opened their wallets to their real masters – Congress. If combined, Fannie and Freddie would be the third largest spender on lobbying over the past ten years. And what happened? Congress berated them for not helping more lower income families to own their own homes. Topping the list of screamers were Barney Frank and Chuck Schumer. But who can argue against helping low income families to put a roof over their heads? It’s like cancelling Mothers’ Day. Meanwhile, Fannie and Freddie’s share of the higher credit worthy market was slipping. Oh, and there’s the fact that Fannie lost $2BN in 2007 and Freddie lost $3BN, due largely to their sub-prime practices. The first risk management failure was that of political risk management by both the execs at Fannie and Freddie and the politicians themselves.

If the taxation incentives, monetary policy (let’s not forget the low lending rates fostered by Greenspan), and political motivations created an unhealthy growth in the sub-prime market, derivative products ginned up the market. Now, don’t get me wrong, there were predatory lenders and borrowers and mortgage brokers providing patently false information that no bank ever verified. Some of this was illegal at the time and needs to be prosecuted. Most of it, negligent, legal, illegal or just stupid, is largely a moral hazard of the Fannie and Freddie system in the first place. But all of these problems together would not be enough to cause a crisis of these proportions. For this we needed leverage. And when you need leverage, look for a derivative product.

Here’s where everyone’s eyes glaze over and my real work begins. For everything I’m about to say, and most of what I’ve already said, there are nuances, digressions and complications. But, hell, some of the people who sell these products are not the sharpest tools in the shed. And if they can figure out these products' basic contours, you guys can too. So, here I go… An option on a stock, the right to buy the stock at a particular price within a set period of time, is a derivative product; it is not the stock itself, the option derives from the stock, put differently, the stock is the underlying asset from which the option derives. Derivative products are financial instruments that are anything but the underlying asset itself. Most often they provide leverage because, like the option, a smaller amount of money (the cost to purchase the option) can be used to participate in a much greater share of the underlying asset. However, there is greater volatility in this leverage and small changes in the value of the underlying asset will have greater effects on the value of the derivative.

One type of derivative product is a swap. Put simply, in a swap transaction two different types of risk are exchanged, but not their underlying assets. For example, a payment stream on a fixed rate loan is exchanged for a payment stream on a floating rate. The actual principal of the loans themselves is not exchanged. For example, as a financial institution, I have loaned somebody a fixed rate loan of 7% and I receive those payments; you loaned someone the same amount of money at prime plus 4%. For our various reasons, we enter into a contract between ourselves to exchange those cash flows, but not the underlying principal.

Unlike options which are classified as a security and regulated by the SEC, swaps are contracts and regulated by the self-regulatory industry association ISDA in London. Swaps are not regulated by anybody in the United States. Let me restate, swaps are not regulated at all in the United States. Worldwide these privately negotiated derivatives have a notional, i.e. underlying asset value, of well over $400 trillion. These numbers are huge. For a little perspective, the GDP of the United States in 2007 was about $14 trillion. It would take the entire output of the United States over 28 years to generate the amount of wealth in the underlying assets that are currently traded in the swap market.

US mortgage-backed securities, with their implicit US government guarantees, when combined with lower quality debt, can be used in swap transactions to increase one swap partner’s creditworthiness. They can also be used to reduce the amount of capital that an institution is required to hold because of their perceived low risk quality. So, global financial institutions use mortgage-backed securities in two ways, one derivative-related, and the other to shore up their capital on hand. Firstly, in swap transactions one party may bundle an A-rated debt instrument with the AAA-rated Fannie debt instrument and now have a package that looks like its AA-rated. Secondly, they hold mortgage-backed securities as regulatory capital – what financial institutions are required to hold in cash so that there’s money in the till if there’s a run on the bank. When these instruments turned out to not be as creditworthy as advertised, it blew a hole in the creditworthiness of many financial institutions; it reduced the amount of regulatory capital that they thought they had and caused some counterparties to default on their swap obligations.

Enter our next culprit – the credit default swap. This one will be easy to explain. It’s not really a swap at all. A credit default swap is an insurance contract. But due to the Commodities Futures Modernization Act of 2000 (one of the sponsors of which was McCain economic adviser Phil Gramm), so called credit default swaps could avoid the minefield of US insurance regulation and in fact, any regulation whatsoever. I’m not kidding. The law specifically banned the regulation of credit default swaps. OK, I confess to a little sympathy with the insurers here. Insurance regulation is messed up in this country. Insurance is regulated on a state-by-state basis, creating 50 different regulatory authorities. I want to digress here, but it wouldn’t help to explain the crisis. Let’s just say that insurance regulatory reform has to be a part of the solution. Of the over $400 trillion in swaps, approximately $62 trillion is the insured value of the credit default swaps.

A credit default swap is an insurance policy where the insurer takes a premium and guarantees that a counterparty won’t default on an obligation. Typically, what they’re insuring are payments on swaps. They insure that the counterparty to a swap transaction will continue to make its payments. As an insurer, those who demand the insurance will have conditions in place so that if the insurer’s credit rating slips, the insurer has to have at least enough money in the bank to make good on certain claims. As the insurer becomes less solvent, it needs to have more cash on hand. But it’s tough to have that kind of cash on hand when 30% goes out the door in the form of payroll each year. The average salary of an employee in AIG’s credit default department was $1 million. That includes mail room and secretaries. Average. Salary. Bonuses were on top of that. Greed wasn’t a culprit in the sense that it cheated a pensioner out of her retirement savings. Greed was a culprit because it robbed the kitty of the funds it needed for a the rainy day when the insurer has to make good on some defaults and because bonuses weren't tied to any risk measure, but just based on that year's profits alone for products whose profitability can be extremely variable over time.

Don’t think of default as never going to pay. Default just means missing some interest payments. But if the insurer has to start making payments, immediately the value of that policy sinks like a stone. The value of the insurer’s assets (the policy) drops, the insurer has to maintain more cash, yet with other defaults, the insurer has to make more payments, and the value of the insurer’s assets drops again … and you can see the vicious cycle at play. Not to mention, the kitty had been robbed by the financial geniuses who leveraged their institutions up to record levels. This is the story of AIG, where the former head of the credit derivative department earned $280 million over the past 8 years and he continues to earn $1 million a month while in retirement. Unfortunately, no kitty would have been sufficient for what befell AIG. The Fed came in and nationalized them with $84 billion, of which they’ve already spent $61 billion and the Fed just said that they would be willing to provide up to $38 billion more. No matter how rapacious the guys doing the transactions were, they weren’t skimming $122 billion off the books in bonuses. The problem of greed was compounded by the leverage of the instruments.

With all this leverage in the market: the credit default swaps, which are derivatives of the swaps, which are derivatives of any number of underlying assets, including mortgage-backed securities, which are derivatives of the mortgages themselves, the volatility can be insane as the value of the derivative products can go to zero much faster than that of the underlying assets themselves. The value of the credit default swap once an insured starts defaulting - zero. The value of a swap made up of defaulting mortgage-backed securities - anyone's guess, but zero is a safe one. You can see how use of leverage in a period of declining valuations can quickly reduce a firm's asset base.

So what does everyone want to do at a time like this – deleverage! Enter the credit crisis. It becomes a little easier to follow from this point forward because I have to rely less on financial instruments and products and come back to policy and the more understandable sheer panic. Suddenly everyone wants to sell what have come to be called their “toxic assets” but like the insurer, financial institutions have to have a minimum amount of cash in the bank – called a capital adequacy standard. The amount of cash on hand doesn’t have to be greenbacks, it can be in cash equivalents – like commercial paper issued by reputable companies like say, Lehman Brothers. If you thought it was hard to value your derivative products which are crashing to zero (although zero would probably be a good estimate) what value do you put on a 3 month piece of commercial paper from a huge multi-national firm that just yesterday seemed a picture of health. This isn’t a derivative product, this used to be treated like cash. What happens now if you have commercial paper from Hypo Real Estate Bank in Germany? Hypo is leveraged at 100 to 1 (although as the value of their assets falls, that ratio will be different again tomorrow) and just got a bailout from the German government. What’s their paper worth? Or General Motors, who just compelled to irrationally declare that they are not going to file for bankruptcy. But what if they keep some of their cash in a deposit institution that does declare bankruptcy and they don't have access to some of their cash in three months? Now panic sets in.

This is where I think that the comparisons to 1928 fall flat. This isn’t a crisis of a financial marketplace. It’s a bank panic, a crisis of liquidity in the credit markets and total confidence in the financial markets. This is clearly more like the bank Panic of 1837. And that flashback actually brings us up to the present. But before we get to “What’s Going On Now?” here are those promised bullet points:

What Happened?

• Government policies incent home indebtedness over home ownership
• Government institutions were compelled to take dubious sub-prime mortgages and guarantee them
• This created a moral hazard that mortgage providers used to generate more mortgages and then sell them to Fannie and Freddie
• The mortgage-backed securities were used to fulfill requirements for cash on hand in financial institutions, because they were almost as good as cash
• And they were also used to gin up the quality of financial instruments that rely on the use of leverage
• The global market in these instruments is $400 trillion. In 2007 the GDP of the US was $14 trillion.
• Not only does this leverage create greater volatility, many of these financial instruments trade in an entirely unregulated marketplace
• Wall Street paid bonuses that weren’t linked to the risk that they were taking on, but based solely upon the profitability of instruments that can be at times very profitable and at times very unprofitable. Some of these bonuses should have been saved for this rainy day
• As firms tried to sell the bad assets and reduce their holdings of the more volatile financial instruments that rely on leverage, there came a point when no one would buy
• Storied institutions with long standing favorable credit ratings began to fail
• Insecurity about who might be next poisoned the market and everybody stopped lending
• The engine that makes the world go around, credit, is coming to a halt
• Once the wheels of credit jam up, and banks can’t borrow and won’t lend, everyone began to feel the pain

What’s Going On Now?

It’s hard in the middle of a battle to assess what the field really looks like. But let me suggest that there are two elements to the crisis. One is market-based crisis of confidence and true erosion of capital and the other is various governments’ tactical approaches to dealing with the crisis. I have addressed the underlying issues in the crisis of confidence and erosion of capital in the What Happened section. Suffice to say, it is continuing and accelerating. The scope of the problem is too big for the financial institutions themselves to remedy. Fortunately, unlike in 1837, we have a central bank as a lender of last resort and a government willing to take tactical actions. (I separate tactical from policy because we haven’t even begun to address the policy requirements yet and any of the actions taken now are purely reactionary and entirely necessary.)

The $700 billion set aside for the bailout is going to be insufficient to the task. While it’s a good start, lending institutions clearly don’t think that it’s going to be sufficient. Credit markets are still seizing up. The indicator to look for in this market is the TED Spread which is a measure of banks’ willingness to lend to other banks. It is the difference between the interest on a 3 month US government bond and the rate at which banks lend to other banks. It has increased over 1,000% since the beginning of the year.

The only way to increase banks’ confidence in other banks and to start the wheels of credit turning again is to ensure lenders that the borrower is well capitalized and will repay the loan. It’s going to take months to clean up the balance sheets of these financial institutions with so many leveraged and defaulting assets on their books. But we don't have that kind of time and need to restore confidence in financial institution's abilities to weather this storm today. What everyone knows to be good money is government money. And that is why the Fed has stated that it will start buying stocks of banks. The likely way that this will work is that financial institutions will sell their own stock that they have in treasury (a reserve of stocks already issued but not available for sale). This will dilute existing shareholders, but it will provide the institution with immediate, much needed, capital.

These share purchases will make the government a shareholder in the bank, which is fraught with conflicts of interest and other problems (although except for shareholder rights, the shares will be non-voting), but it is the fastest way to restore confidence and provide a solid capital base from which the bank can both lend and against which it can borrow. Once the government becomes a significant shareholder, lenders can assume that the bank won’t go bankrupt as it has the backing of the government. (Note that in Paulson's speech announcing this, he did not guarantee the liabilities of these institutions - which I was surprised not to hear and could be a big problem in the plan.) That said, some governments may not be powerful enough. Iceland nationalized its largest bank and the share price remained unchanged at 18 cents, meaning that investors think that the government of Iceland about as likely to go bankrupt as its largest bank.

Dropping the Fed Funds Rate, which will affect the interest rate that people can borrow at is another approach. Governments across the world just did this the other day, dropping interest rates a half a percent.

Although I feel that it’s less effective than buying shares in financial institutions, buying the bad assets is another approach. This will at least help to clean up borrower’s balance sheets and make it less likely that they will fail. But I don’t feel that this approach carries the same effect of a restitution of confidence that buying shares outright does because financial institutions themselves don't feel that they know which of their assets are bad and which are not. Morgan Stanley's likely going to be downgraded. It's shares dropped more than 40% in one day. If Citi is holding $1BN in Morgan Stanley's commercial paper, which just three weeks ago was thought to be a cash equivalent asset, what is the value of that today? Financial institutions lack the confidence in their own ability to assess bad from good.

There also should be some kind of guarantee on commercial paper. This will help the other engines of the lending machine, the money market funds. The Treasury has already issued a temporary guarantee of money market funds, but they may need to guarantee the root issue as well - the commercial paper market.

And, hey, McCain does have a point, maybe some mortgages should be assumed directly by the government. It’s the least likely way to infuse any liquidity into the credit market. But it will make some people happy with Washington and it’s so damn apple pie that you can’t argue against it on the campaign trail. And, most importantly, it’ll make the Treasury Secretary’s other actions easier to do by placating a few constituents.

The catastrophic erosion of capital in the stock markets is a direct result of the credit crisis. But too much attention is paid to the value of the Dow Jones Industrial Average. We need to be focused, and I think that the regulators rightly are, on the credit crisis. Despite some high profile bailouts, there’s been little done so far, so it’s hard to point out winners and losers. But there is one unsung hero in this whole thing, Shelia Bair, chair of the FDIC. Amidst the bankruptcy of IndyMac, all the crisis and takeovers, 8% of Americans’ banking deposits moved from one institution to another. Except for some depositors in the bankrupt IndyMac, nobody who had their money transferred from one institution to another has lost a dime. The transitions have been smooth and seamless. WaMu depositors were welcomed to JP Morgan Chase the day after the acquisition and all their deposits were just as they had been. Somebody better treat Ms. Bair real well when she steps down.

The bullet points for What’s Going On Now:
• It’s a crisis of confidence and a credit crisis
• Washington and other governments are using all the tactics available to them to get the wheels of credit turning again
• Some of these tactics are: investment directly in banks, purchasing the bad assets from banks, refinancing and holding individual mortgages, lowering the interest rate
• The combination of these tactics will likely cost more than the $700 billion already allocated
• Shout out to Shelia Bair at FDIC (Bush may have picked Brownie – but for this crisis, thankfully he picked you!)

What Is To Be Done?

In the spirit of the nationalization of major financial institutions, I thought I’d entitle this segment after Lenin’s book.

Firstly, the current tactics that are being used by the Fed and the Treasury seem to me to have validity, they have the approval of Congress and there will be a calling to the carpet once the first $400 billion is spent. They should continue doing what they’re doing. But they will need more money and Congress should start looking to how it’s going to fund it.

Derivative Instrument Transaction Tax
For the next ten years (at least) there should be a tax on derivative instrument transactions. Taxpayers have just eaten a load of externalized costs associated with these transactions. We should make the securities industry internalize these costs by making them pay a tax on the transactions themselves – not just profits. Portions of this tax should be set aside for regulator training, FDIC, SIPC and a yet to be established money market insurance fund. There is at least a $400 trillion marketplace out there (that’s just the size of the swap market). We should get some of that back.

Home Ownership Incentives
I have misgivings about the whole nature of or rationalization for home ownership incentives. But arguing against them would be like trying to strip baseball of its national pastime title. So, let’s assume that we have to have some. I think that we should find a way to incent the “ownership” portion and not the “indebtedness” portion on a home owner’s primary residence. Reward the repayment of principal rather than the payment of interest. Admittedly, this doesn’t help first time buyers in the early years of their mortgage payments, which will be a problem in getting any traction for this kind of a change. But it’s got to be put on the table.

Shoot Fannie and Freddie – worry about Ginnie later
Once liquidity has been restored to the credit markets (in 5 – 6 months) we should begin what will be a long wind down process of Fannie and Freddie. They should slowly stop buying mortgages and slowly try to unload their inventory. Eventually, they’ll be stuck with the real duds and the American taxpayer will get a bill. But we have to cut out our guarantee of the middleman.

Unify the Regulatory Authority for All Financial Products
FIRE – Finance, Insurance and Real Estate – this should be the clarion call for regulatory reform. Insurance regulation should be nationalized. All financial products should be regulated by a federal authority. The era of self-regulation should end. A cry from the industry will go up that these products are so complicated that the feds won’t know what they’re regulating. Bullshit. Compensate adequately and you’ll find many people willing to do 9 – 5 work as opposed to the life of ulcers and early mornings they’d be giving up. Assess capital adequacy standards. Should they go down in times of crisis so that more funds can be available, or should they stay high so that the money’s there if people come calling? I don’t know, but capital adequacy has to be a part of the regulatory overhaul. Should leverage, like capital, also be regulated? Should there be maximum leverage requirements. Remember, Hypo in Germany is leveraged to the tune of 100 to 1. Long Term Capital Management was leveraged to the tune of 30 to 1. Something has clearly come unhinged in our permissible leverage ratios and this should be open to regulation in the future.

Shareholder Actions and Executive Compensation
Somehow there’s got to be a government motivated PR campaign to get compensation boards to tie executive salaries to a measure of risk called “risk adjusted return on capital” or RAROC, so that the risk of the profits are taken into account when determining compensation. If the execs have to eat RAROC in their comp plans, they’ll definitely force it down the ladder. This is a tough to implement because it requires shareholder action, but a broad information campaign may force the issue. It should definitely be implemented in any institution where the government has taken an ownership stake.

Government Guarantees
We’ve raised the FDIC insurable amount to $250,000, but are there other federal insurance programs that we should have in place? There’s SIPC, but it’s a joke. It’s run by the securities industry and seldom, if ever, pays on a claim. While we’re at it, the Feds should nationalize SIPC and look into providing some guarantees to individuals for money market funds and possibly commercial paper.

Mandate Specific Risk Management Practices Within Financial Institutions
Clearly there’s been a failure of risk management practices within financial institutions. We’re going to have to sift through the rubble to figure out where they failures lay and what could be done to strengthen them. But once we know, we should make these risk management practices part of the regulatory regime and enforce them.

I’m sure that there are many more ideas that will come from this crisis and these are just the few that I can think of. So again, for you lazy speechwriters, here are the bullet points:

• Tax complex financial transactions and use a portion of the proceeds to train regulators
• Reward home ownership, not indebtedness
• Wind down Fannie and Freddie
• Unify regulation across all financial and insurance products, end the self-regulatory regime and hire competent dedicated regulators who believe in free and transparent markets
• For all the companies that the government invests in make executive compensation tied to the risks that they take and encourage others to do the same
• Create an additional government insurance program for individuals who invest in money market funds
• Regulate risk management within financial institutions

Eventually, the government should divest itself of its holdings. The direct investment in financial institutions will likely be profitable over the span of a few years and there may even be some interest charges that the government will take. Some of the "toxic assets" will prove to be not so toxic after all and can be sold back to the very same financial institutions at a premium. Hopefully those gains will cover the losses incurred from assumed "toxic assets" that are truly worthless. The taxpayers will likely get their money back and we will be living in a different style of economy than we have been for the past thirtyish years.

If you’ve actually read all of this, thanks. It’s the world as I see it, and as these are huge issues with many contributing factors, I’m willing to be wrong on some of these issues. But, in the absence of any substance from above, I wanted to give it a shot. Hopefully it helps.

Cheers,

Adam