The Moral Hazard of Subprime Risk

"The creatures outside looked from pig to man, and from man to pig, and from pig to man again; but already it was impossible to say which was which." George Orwell, Animal Farm, February 1944

Thanks to our readers for the comments about our missive regarding bank capital adequacy, Basel II: Do Big Banks Need More Capital? Of note, the IRA Bank Monitor will release revised Q3 Economic Capital and Expected Loss numbers for the largest US banks at the end of next week. Suffice to say both number are going up from Q2.

This comment from one reader we found particularly striking (the names of three leading mortgage lenders omitted):

I read your article on trouble at Citigroup (NYSE:C) and others, and bank transparency and soundness issues. I used to work at XXXXX and YYYY. Bad career move. At XXXXX we were encouraged to use sub-prime loans rather than FHA or the FANNIE A- because we made more on sub-prime. Our portfolio of A- was fine, but we couldn't package it for what they did the sub-prime loans. Then we could just keep getting lower and lower quality loans approved. I think some one should look asset wise at ZZZZ's sub-prime approval engine. I did almost no sub prime loans and those I did were special situations and of very high quality. I watched the industry just prostitute itself...

If you know anything about the subprime mortgage crisis, know this: the hundreds of billions of dollars in losses incurred by banks, investors, home owners and others largely are due to government intervention in the private market for home loans going back decades. You can blame the mortgage bankers or ratings analysts or Sell Side traders for the subprime mess, but deregulation, active encouragement by regulators of bank dealing in derivatives, and policy efforts like the push for "affordable housing," are the root causes of the crisis.

An unholy alliance between the real estate, mortgage lending and securities industries, the "men" in Orwell's wonderful quotation, and the Washington political and regulatory elite, obviously the "pigs," has brought the US economy, the dollar and millions of Americans to the verge of a serious financial calamity. The mounting financial crisis emanating from the collapse of the market for complex structured assets also illustrates the huge damage done to the US economy by a financial culture which lacks accountability. The banksters and their political patrons on Capitol Hill profit enormously during boom times, but when the wheels fall off the wagon, the Masters of the Universe scurry back to Washington looking for a public bailout.

Consider how little accountability is demanded today from managers of the largest banks. In 17th Century Britain, the owners of banks had unlimited liability for their institutions. There was no deposit insurance, no central banks or overnight funds market. To own and operate a bank meant you put your entire net worth on the line. Likewise in the US, before the liberal financial reforms of the 1930s, shareholders of banks had double liability, meaning that for every dollar in bank stock owned, an investor had to be prepared to invest another dollar upon call if the bank's capital were impaired. Banks were forced to put a premium on asset quality and liquidity because to do otherwise meant failure for the institution and personal financial ruin for the owners.

After the Great Crash of 1929, the US Congress eliminated double liability for bank shares and substituted government regulation for personal responsibility, both for the managers of banks as well as consumers. Out of previous financial meltdowns a century ago came the Federal Reserve System, the FDIC and a regime of government regulation of banking and finance which, while initially effective, ultimately failed to restrain the return of extreme risk taking to Wall Street.

Today bankers privatize the profits and socialize the losses, to paraphrase Jim Grant. Imagine how different the behavior of the largest, universal banks would be today were the officers, directors and senior managers required to keep most of their net worth invested in their employers equity. Do you think that Countrywide Financial (NYSE:CFC) CEO Angelo Mozillo would still be laughing had he not been allowed to sell the bulk of his shares earlier this year? For those of you unaware, Mozillo's stock sales are under investigation by the SEC.

In place of personal responsibility, we now have a financial culture that feeds on moral hazard. Until just a few months ago, our political leaders and bank regulators encouraged banks to issue risky, illiquid securities based on deceptive quantitative models and dubious Sell Side ratings. As Wilbur Ross told Institutional Investor last month: "I don't think it's just the ratings agencies which did a poor job. It points to a big problem with modeling. Wall Street has gone a little berserk with its reliance on modeling. When the subprime thing blew up, and the quantitative hedge funds got smacked by volatility, they wrote fairly pathetic letters to investors, that basically said things like, 'Well, this was so many standard deviations from normal that we couldn't cope with it.' Well, what good is a model if it can't cope with what actually happens?"

Notice, for example, that Federal Reserve Board Chairman Ben Bernanke has completely reversed his earlier, free market position opposing an increase in the ceiling on jumbo mortgage loans eligible for purchase by two Depression era entities, Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE). After spending quality time with Treasury Secretary and former Goldman Sachs (NYSE:GS) CEO Hank Paulson, Bernanke now publicly embraces a plan for the Treasury to guarantee jumbo mortgage loans to be purchased by the GSEs. Unfortunately, the GSEs already have the same asset quality problem as do the commercial banks and a lot less capital. Both GSEs may be looking for a bailout from the Treasury as well. The key thing to understand is that each time the financial markets or the real estate sector are "rescued" by Washington, the seeds of the next crisis are planted and the US economy is pushed further in the direction of statist mediocrity. Financial services analyst Josh Rosner described the public/private roots of the subprime crisis very nicely at the September 20, 2007 event on the rating agencies sponsored by PRMIA which we excerpted (The Subprime Crisis & Ratings: PRMIA Meeting Notes, September 24, 2007).

So what we saw actually was the largest public-private partnership to date, started as the National Partners in Home Ownership in 1994. It was signed onto by the realtors, the home builders, Fannie Mae, Freddie Mac, the mortgage bankers, HUD. It was a massive effort, with more than 1,500 public and private participants, and the state goal was to reach all time home ownership levels by the end of the century. And the stated strategy proposal to reach that goal was, quote: 'to increase creative financing methods for mortgage origination.' Those seeds were sown in 1994. Those policies were put in place in 1994. By 1995 we saw home prices start to rise and home ownership levels also start to rise. How did we do that? There was no private label [mortgage] market at that point. We were really dealing in a world of enterprise [GSE] paper. We saw most of the features [of CDOs and structured assets] that we are now looking at as having been atrocious or irresponsible or poor risk management having started in the enterprise markets. We saw changes in the LTV, changes from manual underwriting to automated underwriting. The approval models used were easy to game. We saw reductions in documentation requirements. We saw changes for mortgage insurance requirements. We saw the perversion of the appraisal process and a move to automated appraisals. All of these features which we now look at and point our fingers at the subprime originators and say 'you bad boys,' all started in the enterprise market. This, by the way, is why I believe there is still significant risk [in the GSEs].

Rosner tells The IRA that as Washington crafts a bailout for the Sell Side banks, he expects to see a number of members of Congress become embroiled in the next 'Keating 5' scenario. "Given that we are not talking about a relatively small institution like Lincoln Savings and Loan, it appears the number could easily exceed five," he adds optimistically. When you see regulators like FDIC Chair Sheila Blair publicly telling banks to make wholesale modifications in mortgage loans -- or face legislation by Congress to do just that -- the table is obviously set for some back-door gratuties. You also know that the asset quality situation in the entire financial sector is deteriorating rapidly and that the spillover into the rest of the credit markets and the larger economy is only just begun.

Speaking of spillover, we hear that the three largest ratings agencies are under a full-court press by regulators and the Treasury not to downgrade the "AAA" ratings of the monoline bond insurers, a situation reminiscent of when former Treasury Secretary and then Citigroup Chairman Robert Rubin tried to prevent Moody's (NYSE:MCO) and S&P from downgrading Enron. By the way, our Maximum Probable Loss for C's lending operations was 400bp as of June 2007, but we expect to see C's actual losses from lending reach that level by mid-2008 vs 110bp as of Q2, a level of loan defaults comparable to the early 1990s. Think Bob Rubin can swim in water that deep?

Our favorite market voyeur, Gillian Tett of the Financial Times, notes that Fitch is openly forbearing on a downgrade of both Ambac (NYSE:ABK) and MBIA (NYSE:MBI) by giving each "a period of time in which they can raise fresh capital to avoid downgrades." Good luck selling that paper. With credit derivative swaps for the "AAA" rated debt of MBI and ABK trading in the 300-400bp range, the markets are telling investors that these are really "BB" credits. Caught between regulators and politicians, on the one hand, and their shareholders and the trial lawyers on the other, the Sell Side ratings agencies and auditors of the big banks are living in a world of pain (more on this in the next issue of The IRA ).

Several months ago, we suggested that a sharp decline in consumer credit quality would be the natural follow-on to the chaos in the market for structured subprime mortgage assets. Indeed, looking at the numbers for Q3 from the major banks, we feel even more strongly that mounting consumer credit losses, this in addition to mortgage-related trading book losses for banks and investors, will be the headline story going into the November 2008 election. Americans may even see a major bank insolvency before going to the polls next year, this as the subprime fiasco blooms into a generalized economic crisis.