Chapter 2. The Biggest Gamblers Go “All In” on the Housing Bet

By now, we have reasonably illustrated the deterioration in the mortgage market from responsible borrowers refinancing their homes in early 2001 to 2003 to the runaway speculators betting on higher home prices in 2006. We have described many of the key actors in this comedy of errors, from the spendthrift consumer looking to monetize his house’s appreciating value, to the house price speculator buying up second and third properties, as well as the mortgage brokers, policy makers, and hedge funds that all helped make it happen. Conspicuously absent from our roll call have been the real players in the mortgage securitization charade, the big fishes in the pond, the real borrowers, the real house price speculators, the real hedge fund operators—the investment banks. Everyone else in on the game until now was small potatoes. As we noted earlier in our discussion, the investment banks picked up on the securitization game in 2003 and doubled their share of the securitization market in just three years. Without question, Wall Street was designed for this game, and it played it like a master. Problems took root when the investment banks transitioned from merely shuffling these securities out the door to their customers to consuming them in house too. Wall Street’s transgression from seller to consumer in this market can find any number of sad analogies—the bookie turned gambler, the bartender turned drunk, the drug dealer turned addict. Obviously, those analogies have negative connotations. The outcome of the investment banks placing these securities, or exposure to them, on their balance sheets provides no less of a bad outcome.

At the beginning of the credit boom, the investment banks were content to generate steadily increasing profits from the basic securitization process. But the relentless pursuit of higher bonuses and compensation was inseparable from the culture of these firms. With that said, it is no surprise that these firms sought and eventually discovered new ways to monetize the credit bubble. In the stand-alone securitization model of the business, the investment banks simply brought new issues of collateralized debt obligations (CDOs) and various other credit vehicles to the market for purchase by institutional-size investors. The profit came from charging a fee, not unlike their classic business of delivering an initial public offering (IPO) to the equity market. Once the deal was done, the search was on for the next one. This model generated few potential risks, with the exception of a potential loss of income from prior levels once the new business slowed in growth. However, another major component of the investment banking revenue stream comes from trading on both an agent and principal basis. The allure of trading these asset-backed securities for profits on behalf of the firm, and supposedly its shareholders, provided the impetus for an unmatched level of financial risk taking. The most terrific and easily visible of the investment banks’ adventures into direct investing in asset-backed securities lay in the creation of two hedge funds by the 85-year-old firm Bear Stearns. In 2003, Bear Stearns established the High Grade Structured Credit Fund as a hedge fund that invested primarily in investment-grade CDOs backed by mortgages. It was also a vehicle that borrowed money in the short-term repo markets to invest in tranches of CDOs. The idea was simple: borrow at one low rate, and invest in asset-backed securities to earn a higher rate. The returns the hedge fund would generate could scale with the amount of leverage that the fund employed, all other things being equal. This game plan worked like a charm from its inception in late 2003 through 2006 as the fund recorded 40 months of returns without a loss. The fund was so successful, and the managers were so confident in this mortgage- and asset-backed market, as well as their own abilities, that they launched a second fund in August 2006. It was called the Enhanced Fund, which in financial parlance means more leverage. More leverage, indeed. The Enhanced Fund was borrowing on the order of $20 for every $1 that an investor had contributed.

Trouble in Paradise

By the time spring 2007 arrived, these funds had been heavily feasting on the aforementioned subprime meat of the fixed-income market—and they had been using a great deal of borrowed money to do so. Perhaps blinded by their success, as often happens to investors, the fund managers did not feel the tremors that signaled that the ground was about move beneath them and swallow them whole. Incidentally, some of the rancid inventory of subprime credits that had been scraped up by the sales-driven mortgage originators was spoiling on the shelves of these hedge funds (and countless others). As early as February 2007 the funds began to show their vulnerability to the subprime market defaults as the Enhanced Fund lost money that month. Conditions continued to slip in March 2007 as the High Grade Fund lost 3.71% and the Enhanced Fund lost 5.41%. This was the same month that the fund’s manager, Ralph Cioffi, removed $2 million of his money from the Enhanced Fund and simultaneously reassured investors that everything was OK. This suspicious behavior eventually landed him a date with Federal investigators. At the end of April, the Enhanced Fund’s managers had just reported to its investors that it was down 10%—or so they thought. The fund had the great misfortune to return to its investors weeks later and issue a reappraisal of its April valuation due to quotations received from one of its trading partners, Goldman Sachs. As it turned out, Goldman was already beginning to aggressively mark down market prices for subprime-related CDOs. Goldman’s desk was not receiving offers in the market in line with what many others thought to be the prices at the end of April. Goldman reportedly believed that prices for these asset-backed instruments—that other brokers reported to be closer to 90 cents on the dollar or more—were actually nearer to 50 cents on the dollar. This may seem drastic at first blush, but this is the nature of illiquid assets, and the CDOs that the Bear funds held were thinly traded. The fund managers had little choice but to recognize this updated valuation and incorporate it into their existing fund valuation. When investors received a new letter telling them that their investment was down 23%, rather than 10%, they had seen enough. Investors sought to flee the funds through redemptions, but the fund quickly suspended redemptions because it could not meet them due to the illiquid nature of its investments. Likewise, the fund’s creditors began responding to the declining valuations of asset-backed securities and forced margin calls on the fund. The fund’s creditors had supplied the fund with short-term borrowing contracts, while the fund had invested in long-term, illiquid assets. Sound familiar? Incidentally, these sophisticated hedge funds were taking the same ill-advised risks that the multitudes of home speculators were assuming through their gimmicky mortgage products. By June, one of the fund’s creditors, Merrill Lynch, put little faith in Mr. Cioffi’s assurances or request for a 30-day stay on margin calls. It promptly seized over $800 million in collateral, with the intent to auction the securities. By July the High Grade Fund had lost 91% of its value, and the Enhanced Fund was wiped out. That fast. Moreover, if this looks like a swift demise, just wait. In what was perhaps one of the more foreboding episodes of these funds’ total meltdown, Bear Stearns attempted to rescue them by committing over $1.6 billion of its own capital. Not only did this rescue fail, but it also plainly illustrated that the top brass of the investment banks were deeply out of touch with reality. In addition, it showed just how quickly these securities could annihilate capital.

What transpired in the Bear Stearns episode was a microcosm of what would take place across the world’s capital markets in a little over a year’s time. In sum, many of those reckless borrowers who had been taking out home equity loans to buy Hummers, or second and third mortgages to speculate on future housing price increases, were beginning to demonstrate that they were unable or unlikely to continue sending in payments on their mountain of debt. In fact, subprime defaults were accelerating in early 2007, and housing prices had already started to fall from their lofty highs. The problem among the borrowing base was twofold: Interest rates were beginning to reset at higher levels on the ARM contracts, and housing prices had started to fall. As rates reset, the cost of servicing the loans spiked, and the borrowers faced a stark realization—they could not afford the homes under the new financing terms on their base of income. In fact, the speculators had pushed housing prices so high in proportion to income levels that the relationship was almost hopeless for anyone caught in these loans as their rates reset. Figure 2.1 shows the ratio of national median home prices to median income levels based on data compiled by the National Association of Homebuilders. The data demonstrates that housing prices in relation to income had risen to a level far above the norm, which had traditionally been approximately 3x.

Figure 2.1. National median house price to median income

Source: National Association of Homebuilders

As rates began to reset on borrowers who were already too stretched, the writing was on the wall.

If the Bear Stearns hedge fund managers had the audacity to take $1.5 billion of capital and leverage it into well over $20 billion in investments, what can we say about an entire firm that was leveraged 30:1?

The Canary Died Unheard from the Boardrooms, Yachts, and Golf Courses

Lehman Brothers had enjoyed a longstanding place in Wall Street’s colorful history since its inception 158 years prior to the second week of September 2008. The firm had enjoyed playing a role in cultivating many capitalistic icons from America’s past and present. These included the financing of railroads, as well as storied companies such as Sears Roebuck and RCA, among countless other business feats. Despite its tradition and ability to escape the worst financial disasters on record up until 2008, 2001 and the Fed’s ushering in of the low-interest-rate environment pulled Lehman into the mortgage-backed securitization craze like no other. By the time 2006 and 2007 arrived, Lehman was the top U.S. underwriter of mortgage-backed securities, with 10% of the market. Keep in mind that 2006 and 2007 were probably the worst possible years to be leading the market in securitizing these loans, as our earlier illustration of loan vintages demonstrated. The loans from these years were being extended to the least creditworthy or, put another way, the hardcore junkies of the credit bubble. More problematic for Lehman, though, was its steady consumption of its own cooking, so to speak, or the inventorying of mortgage-related securities and leveraged loans on its own books. Owning a large exposure of mortgage-related securities, CDOs backed by various other credits, leveraged loans, and so on was a problem in and of itself, but borrowing in short-term debt to own them was a cyanide pill waiting to dissolve. One of the more remarkable sidebars to the investment banks’ strategy of using short-term debt to buy long-term securities was that they all had a front-row seat to the Asian Financial Crisis. There, a similar combination of financial mismatches eventually shook the world. From a practical standpoint, the firm’s 30:1 leverage was more than just a gutsy data point. It also meant that every $100 of borrowing was supported by $3.30 of equity, so if the value of the assets declined 3.3%, equity would be wiped out. This was a rigid balance sheet that would simply break rather than bend if put under even the smallest amount of stress. If the rapid markdown of the CDOs in the Bear Stearns hedge funds meant anything, it should have demonstrated that if the defaults occurring in subprime began to spread into what were assumed to be conforming loans, the firms using leverage to own these products should have been deeply concerned. Lehman and other investment banks that were similarly leveraged fell complacent on what was occurring in the subprime market. They viewed the subprime defaults as a problem that would remain in the confines of securities labeled as subprime. This is logical enough, and it was indeed the conventional wisdom spreading from the head policy makers and pundits around Wall Street. What this belief system overlooked, though, was the degradation of the loan originator model that we discussed earlier, where mortgage brokers effectively extended loans to anyone with a pulse and a signature. What the banks missed was that prime was just as infected as subprime—or, better yet, that the packages had been mislabeled.

Up to this point, we have directed much criticism at the abusers of the securitization system inhabiting the point of sale, but they needed assistance too, even if it was somewhat inadvertent. The labelers of the securities, such as Standard & Poor’s and Moody’s (the USDA of the hamburger analogy in the preceding chapter), provided no less of a letdown to investors than the other players in the securitization markets. The role of the credit rating agencies was at best disappointing and at worst involved some malfeasance. Without question, their role involved bouts of incompetence. Any way you look at it, the ratings agencies were on the securitization dole as they collected handsome fees for providing their ratings, just as they would on any normal bond issue (such as AAA or AA). For instance, one of the largest agencies, Moody’s, saw its revenues from structured finance products jump from under $300 million in 2001 to nearly $900 million for two years running at the height of the market in 2006 and 2007. Even if the agencies had also become too complacent to simply charge a fee for services rendered—services in this case being simply running some numbers through one of their prebuilt quantitative models—we can be relatively sure that mistakes were made. In May 2008 the Financial Times reported that Moody’s had erroneously awarded AAA ratings to billions of dollars of a structured finance product during 2006.¹ For $900,000,000 per year, you might think Moody’s could hire someone to actually go through the model and double-check it! What takes this story in a painful direction is that nearly all investors in structured products had placed their faith in the due diligence and credibility of the ratings agencies. To worsen matters, their ineptitude for rating these investment vehicles extended beyond simple oversight or sloppy work and into the more theoretical basis they used to rate the instruments. One example came from a March 2007 conference call between the credit ratings agency Fitch and managers and analysts from a mutual fund manager called First Pacific Advisors. The CEO of First Pacific, Robert Rodriguez, recalled later² that on the call, one of his analysts asked the Fitch analysts to describe their rating process for subprime asset-backed securities, which the Fitch analyst said was based on FICO scores (credit scores) and projected price appreciations of 1% to 2% in the housing market. When the First Pacific analyst asked what would happen if prices in the housing market declined on the order of 10% to 20% over the next ten years, the Fitch representative said the model would “break down” and that AA and AAA securities would have serious problems. The revelation was that at the core, at least one of the major ratings agencies was applying a model as the basis for its ratings that accounted for only one outcome: housing prices that continue to rise. Was anyone not drinking this Kool-Aid? Basically, all the asset-backed investors had outsourced their homework to a group of researchers whose work was, to put it kindly, lacking. The problem was not only that ratings agencies were not performing the thoughtful work that investors had counted on, but additionally that the work itself would be very difficult to perform without solid institutional-level research capabilities. Put succinctly, the securities are difficult to analyze in real detail. The structures of these credits were complex, and the credits themselves could be a hodgepodge of loans coming from different geographies, industries, and originating sources. So if the price started to fall in one of these investments, and the research analyst or portfolio manager wanted to take a closer look at what was going on, this could be a Herculean research task. Then take into account that an entire portfolio could be constructed from these investments, and you get the picture.

So while Lehman Brothers had been piling mortgage-backed securities onto its balance sheet, and was now up to its eyeballs in exposure ($65 billion in 2008), the other investments banks like Merrill Lynch, Morgan Stanley, and Goldman Sachs were at least up to their waists (if not further) in the same morass of securities. More important, all these firms were leveraged to the hilt by the end of 2007. If we take a look at gross leverage (assets divided by equity) across the major investment banks, we can see that Lehman was in pretty good company, as shown in Table 2.1.

Table 2.1. Gross Leverage Multiples (2007)

One good question following Table 2.1 might be, “Why run up so much debt?” This question can be answered in a few ways. The first comes from comments made by an ex-SEC (Securities and Exchange Commission) official named Lee Pickard. In a 2008 article in American Banker,³ he described changes made by the SEC in 2004 that allowed five investment banks (the four mentioned in Table 2.1 plus Bear Stearns) to no longer be constrained to leverage of 12x net capital. The SEC gave exemptions to investment banks with over $5 billion in capital that allowed them to monitor their risk based on an assortment of complex mathematical models, instead of a good old-fashioned cap on the amount of debt they could assume. Why the SEC chose to meddle with a regulation that had worked for decades is puzzling. Nevertheless, shortly thereafter the amount of debt these banks employed mushroomed. Still another answer to the question about using so much debt on their balance sheets lies in their ultimate incentive to assume this financial risk. That incentive was the enormous sums of money that were being made at these firms during the credit boom. Understanding the bulge bracket investment banking culture and their motivation is simple: aggressive, profit-driven, and Darwinian. If we take a quick jaunt back to 2001, when the Fed was embarking on its adventures in interest rate experiments, these firms, for all and intents and purposes, were still reeling from the fallout of the dotcom mania. Massive layoffs, corporate governance scandals, weak profits, and an easily foreseeable witch hunt by anyone who had lost big in the tech bust. Let’s face it—times were terrible in the early 2000s for the investment banks. Then, along came those low interest rates. As soon as they were combined with a growing securitization market, these people knew how to turn a buck, and it was off to the races. This phenomenon is easy to see in the historical revenues and compensation levels of the aforementioned investment banks, shown in Table 2.2.

Table 2.2. Let the Good Times Roll: Revenues and Compensation Expenses for the Major Independent Investment Banks

As is evident from Table 2.2, all the major independent investment banks enjoyed a sharp acceleration in their revenues and, not surprisingly, in their compensation expense. Even with the rush of wealth flooding the halls of these banks, Lehman stood out as exceptional with its 21% compound annual growth in revenues from 2001 to 2006. Equally exceptional was the compensation at the firm. Richard Fuld, Lehman’s CEO, earned over $80 million during 2006 and 2007. The other bank chiefs also made out well. Lloyd Blankfein, the CEO of Goldman, pulled in $54 million in 2006, and John Mack, the CEO of Morgan Stanley, made just under $47 million in the same year. The investment banks quickly learned in the credit boom that using cheap money to increasingly expand their operations into the securitization boom was profitable to everyone involved, especially at the top of the organization. Without surprise, we have once again identified players in the credit boom who were borrowing vast sums in short-term funding to tie up in assets with less-than-ideal liquidity. Far from being alone in their exposure to real estate credits, mortgage-backed securities, and CDOs, the investment banks were not the only ones to figure out how to make this system of low interest rates and growth in credit issuance work to their advantage. In fact, the commercial banks were just as eager to play the credit boom. This was despite the fact that commercial banks were more apt and designed to hold loans on their own balance sheets and assume more credit risk (but within the confines of lower allowed leverage than the investment banks due to regulation). Based on available data from the Federal Reserve, U.S. chartered commercial banks grew their mortgage portfolios at a 12.0% compounded annual growth rate from 2002 to 2007, as shown in Figure 2.2. Clearly, this growth was exceptionally high for a mature low-single-digit growth economy and implied that the industry was pushing the envelope on who could receive financing.

Figure 2.2. U.S. chartered commercial banks’ total mortgages

Source: Federal Reserve

Even more ominous than the strong growth in mortgage issuance that occurred in the credit boom was the increasing concentration of real estate loans held on the books of the U.S. chartered commercial banks. Based on data from the Federal Deposit Insurance Corporation (FDIC) dating all the way back to 1934, Figure 2.3 shows that as 2006 came to a close, real estate loans comprised 57.4% of the total loan portfolios in the banking system, an all-time high. Again we can surmise that 2006 was probably the worst possible year to have an all-time high exposure of loans to real-estate-related ventures. But then again, March 2000 would have been the worst possible time to hold a portfolio dedicated to technology shares. The simple fact that all the banks were so heavily concentrated in real estate is deeply foreboding from a contrarian perspective.

Figure 2.3. Real estate loans as a percentage of total loans

Source: FDIC

The Credit Bubble Draws in Every Last Bull

So the stodgy old bankers proved to be risk takers after all. As we said earlier, finance is a commoditized business. If someone is making extra normal returns in an area, it will not be long before the whole industry converges on the scene and pushes down returns on capital to nil. One after another, nearly every financial business in the United States (and beyond, for that matter) was exploiting the credit boom and real estate bubble, through whatever means relevant to their raison d’etre.

Actually, getting hooked into this mess did not always require being a financial business. As the credit boom stumbled along toward its inevitable letdown, many run-of-the-mill commercial producers and retailers of goods tried their hand at the game as well by opening or heavily expanding preexisting financing arms. From a business manager’s standpoint, why not? These finance businesses can carry nice returns on equity through the application of leverage, which can boost profits in an otherwise-mature business. Formally known as Industrial Loan Companies (ILCs), during the credit boom many otherwise-nonbanking enterprises took advantage of an old state chartered banking classification from 1910 that allowed commercial businesses to set up internal financing arms. The idea back in 1910 was to provide unsecured credit for workers at industrial companies because this was a lending business that traditional banks did not engage in at the time. Originally barred from accepting deposits, the ILCs created “thrift certificates” that were de facto deposits under a different name in order to be legal. Because ILCs were barred from taking deposits, they were also disallowed from having FDIC insurance. In 1982, however, the passage of the Garn–St. Germain Depository Institution Act provided for FDIC insurance on thrift certificates. This regulatory change precipitated stronger growth in the category. By the credit boom of the early 2000s, many well-known nonbanking enterprises had become big players in the banking space. For instance, General Electric, General Motors, Target, Harley-Davidson, BMW, Pitney Bowes, and Toyota all had sizable banking businesses, subject to less supervision than what would otherwise apply to a run-of-the-mill chartered banking institution. An example gives you an idea of the type of growth these ILC banks experienced. In 1987 the ILCs had $4.2 billion in assets, and by 2006, as the credit boom was cresting, the ILCs possessed $212 billion in assets. In other words, these businesses posted annualized growth in their various loan books of 22.9% per year from 1987 to 2006. These businesses were doubling in size every three years. This is an irresistible growth rate if you are the largest automobile maker in the world (GM) that is operating primarily in mature-growth economies. To put this in perspective, before GM moved to sell off a stake in GMAC during 2006, GMAC was chipping in approximately 80% of GM’s profits. For all intents and purposes, by the peak of the credit boom GM was a finance company that sold cars on the side.

As the credit boom persisted from its humble beginnings in 2001 to its juggernaut status in 2006, it sucked in as many parties as existed for the taking. Even the most boring, plain-vanilla financial vehicles fell prey to this environment as money market funds, the pooled funds that try to invest cash in near-term instruments for a small yield, gobbled up CDOs. In hindsight, we can reasonably ask what money market funds, charged with safekeeping cash and eking out a small yield, were doing in CDOs. For this, we can again partly thank the credit rating agencies for their AAA seals of approval. The AAA CDOs often produced higher yields than similar AAA-rated instruments that the money market funds were required to hold. Therefore, the fund managers were more than happy to toss these investments into their funds alongside all those sleepy T-bills and certificates of deposit. In short, these holdings made their yields more competitive and still met their “high quality” investment restrictions. In bubbles past, housewives hit the streets of London to trade stock in the South Sea Bubble of the early eighteenth century, and octogenarians traded tech stocks in 2000. Now even the most conservative and unlikely of candidates, the money market funds, had become creditors to the subprime bonanza. In sum, once the last bulls on a bubble get drawn into the mix, no bulls are left in the market to drive the assets higher. And as the market exhausts its supply of bulls, it is set to turn. As this activity fed on itself from that fateful day of June 25, 2003, two major components of the U.S. economy, the consumer and the financial institutions, moving in sync with each other guided their balance sheets into increasingly uncharted territory.

If one clear conclusion can be drawn from Figure 2.4, it is that the U.S. consumer and U.S. financial sector had taken on aggressive debt levels. We can appreciate the large rise in the early 2000s as compared to the preceding 50 years shown in the figure. But based on an even longer-term perspective, U.S. households were taking on debt levels not seen since the Great Depression. That was the last time household debt was in the range of 100% of gross domestic product (GDP).

Figure 2.4. U.S. debt to GDP ratios for household and financial sectors

Source: Federal Reserve

This was an ominous sign. Just as the liabilities side of the consumer’s balance sheet was hitting its highest level since the 1930s, the assets on the other side of the balance sheet were beginning to show signs of weakness. This nascent dynamic in the housing market signaled potentially grave financial circumstances for any borrowers who were overextended. If housing-related assets fell in value, any debt backing them would stay the same in the absence of being paid down ahead of schedule. If we use the Case-Shiller home price index as our market proxy, as shown in Figure 2.5, housing prices across the 20 MSAs included in the most comprehensive version of the index had risen over 85% since the beginning of 2001. They hit an all-time high in July 2006.

Figure 2.5. Case-Shiller composite 20 home price index

Source: Bloomberg

In 2005, three years before the crisis erupted and while the world’s economies were still riding high on the wave of optimism resulting from unchecked spending and easy access to credit, one of the world’s greatest investors penned a memo to his friends, associates, and managers. Rather than displaying optimism, as was customary for Sir John Templeton, he compiled the following thoughts and comments into a piece he titled “Financial Chaos”:

In 2005, these words represented a dark forecast of events to come. By 2008, they proved eerily prophetic.

Endnotes

¹ Sam Jones, Gillian Tett, and Paul J. Davies. “Moody’s error gave top ratings to debt products.” Financial Times, May 20, 2008.

² Richard Rodriguez. “Absence of Fear.” A speech given at the CFA Society of Chicago, June 28, 2007, http://www.fpafunds.com/news_070703_absense_of_fear.asp.

³ Lee A. Pickard. “Viewpoint: SEC’s Old Capital Approach Was Tried — and True.” American Banker, August 8, 2008.