Once the supporting cash flow came under pressure and was questioned several major layers went bankrupt or took tremendous losses. It became apparent risk and innovation had been improperly balanced, a prime characteristic of the CAM paradigm. Indeed, greed, Innovation, and technology had combined to substantially reduce credit quality and increase leverage, vastly expanding the likelihood of a liquidity crisis and a substantial drop in the value of asset-backed securities.
The analysis then examines why this effect had significant global dimensions unlike for example the Japanese real estate and stock market collapse or the US Internet boom and bust. The analysis also shows how market reactions have been in line with what and Edward Graphic anticipated and to normal bank behavior in a credit crisis. See Irrational Exuberance (Sheller, 2005) and Supreme Mortgages (Graphic, 2007). Finally the paper assesses the policy responses to the crisis and their likely success under a CAM paradigm analysis.
The proposed remedies already include the aggressive fiscal and lender of last resort monetary responses typical of the CAM paradigm but regulatory measures too. Further, as CAM notes almost all booms and crashes involve scandals and scams. So not surprisingly there has been growing recourse to the courts seeking criminal and civil remedies. Also typical of such a dramatic boom and bust governments are examining regulatory and legislative actions to address the current difficult economic and credit situation and to make sure similar things do not occur in the future.
But politics and a US presidential election are driving significant differences in approach. Under these circumstances what can the lens of CAM paradigm tell us about the actions taken or proposed and what is or is not likely to work. INTRODUCTION AND SUMMARY OF PAPER’S THEMES AND OBJECTIVES The paper’s argues the bubble paradigm explained in Manias, Panics and Crashes (Kindergärtner and Illiberal, 2005) applies to all aspects of the supreme mortgage crisis from development of the bubble through the legal, economic and political aftermath.
Indeed any reasonable application of the paradigm should have raised early warnings about the housing bubble, its inherent risks and the likely wide scope and disastrous financial and economic impact of a collapse Indeed if used by policymakers to raise cautionary flags it could have served theirs and the publics long-term interests. Further as the CAM paradigm predicts, the supreme mortgage meltdown and its aftermath have brought numerous civil and criminal actions.
For example, mortgage fraud in the US, including Federal and state prosecution, is growing dramatically. Suspicious activity reports related to mortgage fraud increased over 1000% between 1997 and 2005 and pending FBI mortgage fraud investigations rose from 436 in fiscal 2002 to 1210 in fiscal 2007 (Grant, 2008). The huge increases in the US mortgage market and its increasing complexity have opened many attractive opportunities for fraudsters across a range of financial activities and institutions.
The most common frauds involve “property flipping” or other schemes to get proceeds from mortgages or property sales via misleading appraisals or false documentation. The SEC is also looking at insider trading related to unexpected write-downs by publicly traded companies with assets tied to mortgage-backed securities. Further plaintiffs’ lawyers and their clients have been active in making other claims such as misrepresentation or failure to disclose materials information, trying to recover some of the billions of dollars in losses.
However, to grasp the supreme bubble and meltdown in its placement, subsequent crash and current aftershocks, one must first understand the key changes that occurred in the financial markets for mortgage related securities and their legal underpinnings along with how changes in US banking and STRUCTURE AND EVOLUTION OF THE US MORTGAGE MARKET The US residential mortgage market is a multi-trillion dollar market that dramatically increased over the last five years. In June 2007 residential and non-profit mortgages outstanding amounted to $10. 143 trillion up from $5. 33 trillion as of September 2002 (Federal Reserve, 2007) and from $2. 3 trillion in 1989 (Gordon and Goldstein, 2002). In turn the number of firms and organizations participating in this huge market has proliferated. Traditionally up until about twenty-five years ago home loans and mortgage were usually arranged between a local bank or local savings and loan [S] and a local borrower with the bank or S holding the mortgage subject to local real estate laws and land registry regulations until maturity or the home was sold or the mortgage refinanced.
But starting in the asses and expanding into the asses and the first years of this century, that all changed. Banks and S discovered the benefits of serialization and balance sheet turnover. They realized mortgages and other regular payment credit instruments such as auto loans and credit cards had steady cash flows that if bundled would provide investors with a steady income stream that could be capitalized and sold. This led to the concept of scrutinizing these cash flows.
Now banks and S rather than holding the loans in as investments bundled and sold them to investors while retaining the servicing function for which they deducted fees. This innovation meant banks or S could rapidly turn over their balance sheets since they did not have to wait until a loan was repaid or their capital increased to make new loans and expand revenues from loan servicing and origination fees. This process increased return on capital, earnings per share, and shareholder value benefiting shareholders and corporate officers with stock options.
In the asses under the Basel agreements and Resolution Trust Corporation Act, banks and S were subject to more stringent capital requirements relative to loans they booked. This gave them an incentive to no longer hold loans to maturity or payoff. Rather as Just explained it made sense to package and sell them to long-term investors such as insurance companies (Rap, 2004). As the new system evolved and became national or even international rather than local, other financial intermediaries emerged that specialized in specific functions within the overall mortgage packaging and sale to investors’ business chain.
For example, mortgage brokers realized they could sell a New York mortgage to a Washington S&L that might price it more aggressively on rate and term than a local bank. This could be due to the other lender’s lower funding costs, desire to diversify risk across more markets, or interest in expanding id servicing portfolio to achieve economies of scale. Indeed it could be a combination of these factors. Brokers could thus find borrowers the best rate within a competitive and integrated national market for residential mortgages that ultimately squeezed out the small local bank or S. mints in the mortgage financing and investment chain emerged. The development of the Internet and computer power only increased such considerations as technological progress created significant cost improvements in sourcing and processing mortgage applications and approvals on-line. Just as a homebred could now virtually tour several houses in an afternoon without leaving home they could ampere mortgage rates from several sources while lenders could quickly scan a buyer’s credit score.
Similarly huge increases in computing power and telecommunications introduced economies of scale in servicing the mortgages (Rap, 2004) and the investors. Under this new and evolving structure it was quite possible no federally insured bank of S&L was involved in the loan or any one investor would hold the actual mortgage as security. A mortgage broker could find a lender such as GAMMA or GE Credit Services or Merrill Lynch instead of a traditional bank or S&L.
These lenders would bundle the retrogress into pools usually as a trust and either themselves or via investment banks such as Lehman Brothers or Bear Stearns place them with investors (Yamaha, 2008). But rather than selling the pools or percentages of the pool to an insurance company, hedge fund, or structured investment vehicle [SIVA], they sold pieces of the pool’s cash flow tailored to an investor’s requirements. Thus long-term investors might only want the final monthly payments while another, shorter-term investor, might desire only the first three years’ interest.
The longer dated monthly payments would then be sold to a different investor group. Thus no investor owned an entire mortgage and none were involved in the loan administration or handling of the security. In “House of June Fortune details a Goldman Cash deal that highlights these considerations (Sloan, 2007). Large computer systems supported the servicing of these different structures and favored firms that could source and service in volume, spreading the system costs over a large number of mortgages, customers and structured investments.
This led to a factory mentality in creating the pools including the supporting legal documentation, a practice that has carried over to foreclosure activity in the current economic downturn and housing crisis (Moroseness and Slater, 2008). Because the initial lenders only expected to hold the mortgages for a short period they frequently funded the initial mortgage loan using commercial paper. In addition to GAMMA and GE, several specialized mortgage lenders used this technique, including those focused heavily on the sub-prime mortgage market.
In their 2005 annual reports GM and GE indicate this kind of activity and indeed GM indicated $4 billion in mortgage servicing rights on its balance sheet. The Countrywide Financial Corporation [CUFF] perhaps the largest mortgage lender in the US did this extensively with its immemorial paper backed by its mortgages (CUFF, 2007). It did this even though a subsidiary was a federally insured S&L. It continued this funding practice up until 2006, probably to avoid the more stringent capital requirements the government had imposed on S&Ls in 1989 as part of The Resolution Corporation Trust Act (FAIRER, business model.
In 2006 it applied for changed status to a Federally Regulated Savings and Loan Holding Company (CUFF, 2007). Nevertheless, the size of the mortgage financing market, its rapid growth and its increasing complexity have combined with the current meltdown and the billions in asses by financial institutions and investors, to create as the CAM would expect many opportunities for legal actions including criminal prosecutions for fraud and numerous civil actions seeking a legal remedy and some restitution of the lost billions (Hamilton, 2008).
Not surprisingly the points of legal altercation are generally at the intersections that represent handouts of the loans and mortgages between institutions such as the mortgage broker to the lender or between the lender and the packager or the packager and an investor since these points have usually been accompanied by contractual documentation representing the warranties and susceptibilities of the party doing the handing off or the offering to the one receiving or accepting the securities.
These contractual obligations then become the basis for any recovery. However the cookie cutter approach used to produce the securities on mass production basis are now creating problems. This is because the slicing of loan pools into several pieces with varying rights to specific mortgage payments coupled with the multiplicity of documentation at each point in the chain have combined with the split between servicing and ownership to make it unclear who controls the pool or the underlying mortgage loan and its payment stream.
Indeed in several cases the servicing agent holds the mortgage in trust for the pool, while the pool is controlled by the super senior trance for a diverse group of investors with conflicting interests. KINDERGÄRTNER-ILLIBERAL-MINSK PARADIGM This scenario’s boom and bust tracks the CAM paradigm perfectly. So predicting the bust and it consequences was not as difficult as Robert Rubin has posed. Indeed in his book Supreme Mortgages Edward Graphic did exactly that (2007).
The CAM paradigm explains that every mania or bubble begins with some large displacement that changes expectations such as a major technical advance like the Americanization of the Internet, or rapid deregulation like occurred in Japan in the early asses or in the US in 1999 with the repeal of Glass-Stella under Grammar- Leach-Bailey, or a large injection of liquidity like occurred after the Internet bust. In this case, it was mostly the huge increase in liquidity and lower interest rates but this change built on and benefited from the other two.
This was because the elimination of Glass-Stella vastly increased the number of players while the Internet boom had created tremendous and low cost computing and communications power that as scribed above greatly facilitated and accelerated the credit expansion. Once the displacement has occurred related assets start to appreciate. This leads to the interaction of greed, speculation and further asset appreciation or a bubble that continues to expand until the leverage fueling the system can no longer support further expansion or price increases in the asset class. Nice it provides the leverage that fuels the expansion of the bubble on the upside and accelerates the collapse on the downside as banks become more conservative relative to risk and begin to restrict credit. Here the banks’ over-lending to support he acquisition and holding of mortgage-backed securities occurred directly to investors, indirectly via lending by hedge funds the banks funded, and also through various derivatives such as Credit Default Swaps (CDC).
Since leverage for some investors reached over forty-to-one any glitch in the market could set off margin calls and the downward spiral of sales, price declines, and more margin calls that actually occurred, Just as happened in 1929 with respect to stocks. APPLYING CAM PARADIGM TO SUPREME MORTGAGE MELTDOWN – DISLOCATION AND BUBBLE This happened in the US mortgage market as housing prices rose faster than people’s incomes. At first lenders kept the process going through low interest “teaser” loans.
But as the Fed tightened rates and mortgage interest reset at higher rates, foreclosures began to rise and new homebuilders were priced out of the market. These developments caused lenders and investors to reassess the risks and to pull back on new money, leading to a drop residential real estate values. Investors then had to reassess the value of their investments and the stage was set for a CAM panic as heavily leveraged investors tried to convert to cash.
The flood of assets coming to rake combined with decreased demand due to risk reassessment and decreased credit availability brought the inevitable crash. No surprises here. APPLYING CAM – CRASH; SCANDALS AND SCAMS; POLITICAL AND LEGISLATIVE ACTIONS The crisis following the crash and the pattern of its aftermath also tracks CAM perfectly. As Kindergärtner notes historically almost every financial boom and bust is followed by a series of scandals (Kindergärtner and Illiberal 2005).
Since people are usually hurt by the collapse in asset values and especially the ones involving fraud, there is usually political pressure to punish those perceived as having caused the robber as well as to prevent future abuses even though the real reason for the boom is generally the publics greed, in this case using the equity in their homes like an ATM to fund consumption. Still the panic that follows the collapse as the bubble runs out of liquidity to further support much less inflate asset prices frequently spurs “barn-door closing” legislation.
The Federal Reserve, the SEC and Serbians- Solely resulted from the financial crises of 1905, the crash of 1929 and the collapse of the Internet Bubble respectively. It is thus not surprising the US housing market bubble and its collapse, particularly in he supreme mortgage market that was especially subject to broker and lender abuse, has exposed similar bad practices such as predatory lending and no verification mortgages. This as CAM would expect this has lead to subsequent address some of these issues.
Yet interestingly the new legislation Just builds on the intent of Congress in its 1989 legislation, stimulated by the prior LOBO bubble collapse and S&L crisis, regarding loans secured by real estate needing to meet “standards as are consistent with safe and sound business practices” (FAIRER, 1989). Thus the Congress’s response in 1989 and 1990 to the S&L crisis and the Junk bond scandals hen by enacting FAIRER it substantially increased and broadened penalties for crimes impacting financial institutions and tightened capital standards for banks and S&Ls did little to moderate much less prevent the current crisis.
Here one must lay some of the blame for the bubble on the Fed since the controls existed but for policy reasons were not used. EXAMPLES OF CIVIL CAUSES OF ACTION (Rap, 2008) CAM predicts a bubble’s collapse always leads to numerous lawsuits and already many have been filed: the City of Springfield and the Massachusetts Attorney General eave sued Merrill for misrepresenting the quality of supreme COD investments and associated risks.
The City of Cleveland is suing twenty-one Ohio banks under Ohio’s Public Nuisance Law accusing them of reckless lending that is placing a financial and administrative burden on the City due to the high number of foreclosures (Hamilton, 2008). Reflecting the international scope of the bubble and its collapse, the Australian Shire Council of Wintergreen near Sydney is suing Lehman Brothers arguing Lehman improperly sold them risky mortgages.
According to the Financial Times the own claims Lehman had “failed to act in the council’s best interest and engaged in misleading and deceptive conduct while serving as its financial adviser and investment manager by promoting the Lehman-originated Federation COD, which was exposed to the US supreme market. Federation was last month marked down to 16 cents in the dollar. ” The town’s representative claims ‘it relied on Lineman’s advice and representations in making its investments’. ” (Fry, 2007). Meanwhile Lehman is suing Fieldstone Investment Corporation for having sold them “dubious” loans.
Lehman claims borrowers’ income and the appraised home values ere overstated and the conditions of the homes were poor. Their requested remedy that Fieldstone is resisting is to buy back the problem loans. Similarly PM Group, a mortgage insurer, is suing supreme lender WHOM in California to buy back loans PM insured claiming the latter “systematically’ did not apply “sound underwriting practices” and made the loans fraudulently or “in violation of the standards that the lender said it was using” (Baja], 2008).
As evidence for its position the lawsuit states it hired a consultant to review the 5000 loans in the mortgage pool and it found 120 ere defective of which WHOM has only offered to buy back fourteen. Countryside’s shareholders have brought suit in Federal Court in LA against some officers and directors claiming they turned a blind eye to deviations from mortgage underwriting standards. As part of their case the “plaintiffs contend that the officers and directors dumped shares even as the company spent $2. 4 billion to repurchase he had complied with the securities laws under a planned selling program.
But the judge noted in denying his motion to dismiss that he had revised the program several times, each time increasing the shares to be sold, something the SEC isolations do not allow (Moroseness, 2008). Investors in two hedge funds organized in the Cayman Islands that were feeder funds for a Bear Stearns’ master fund have successfully seized control of the feeder funds in a Cayman court by having their own liquidator appointed. The court saw the master fund liquidator as having a conflict. The investors hope control of the feeder funds will give them standing to sue.
The investors argued, “that [Bear] generated and relied upon erroneous net asset value calculations and that [Bear] Warehoused’ or ‘dumped’ unrealizable supreme debt in the feeder funds in contravention of he offering memorandum. ” Further the Judge ruled Bear should share some of the costs as “the bank was behind the decision to put the funds into liquidation ahead of a petition by investors to take control by electing their own directors (Mackintosh, 2008). In another breach of contract case, Merrill Lynch is suing XSL Capital Assurance, a Security Capital Assurance owned subsidiary, for failing to meet its obligations regarding $3. Billion in credit default swaps [CDC]. Merrill said, “We filed suit to make clear that XSL Capital Insurance Inc. Is required to meets its contractual obligations for credit default swaps it agreed to”. Charles Schwab, 2008). Barclay Bank believes itself to be the victim of a hedge fund managed by Bear Stearns that irresponsibly invested investors’ money in complex supreme securities (Larsen and Murphy, 2007). HASH Moorland, a state-controlled German bank, is suing UBS in US Federal court under New York law. It contends UBS improperly sold it complex collateralized debt obligations [Cods] that it mismanaged.
HASH asserts its claims based on “the manner in which the investments were sold to HASH Moorland and Bus’s subsequent management of the assets [being] clearly contrary to [its] interests. HASH claims UBS was supposed to manage the investment conservatively and prudently but did not (Wrigglier, 2008). Under ARISE managers of pension funds have a fiduciary responsibility to act in the interests of their clients. Under a pending case State Street Global Advisors, a subsidiary of State Street bank has set aside $618 million to “settle claims that the firm invested in risky mortgage-related securities” including those brought by five pension plans.
The pension clients claim State Street told them the funds “would be invested in risk-free debt securities (e. G. Treasuries) but were used instead to acquire high risk investments and mortgage-backed securities”. ARISE requires “a prudent man standard of care”. It appears State Street now recognizes Cods backed by supreme mortgages do not meet this test. Many mortgage lenders and underwriters have been accused of taking inadequate reserves or not properly accounting for returned mortgages pools or those held in portfolio even while delinquencies and foreclosures were rising.
In one class action plaintiffs allege Accredited and certain directors concealed the firm’s “true financial condition and made materially false and misleading statements regarding the company’s operations and income. Particularly they cite the firm’s assertions underwriting standards for supreme borrowers were especially conservative and reserve policies for possible delinquent loans or repurchase obligations were more than adequate. Further the plaintiffs allege Accredited did not write down to fair value properties gained by foreclosure.
However, because this was not done, we now have a financial crisis of global proportions with attendant impacts on the US and world economies. So what should be done to address these issues in the short to longer term? Recent lender of last resort actions the Fed and other central banks have taken to assure market liquidity as per CAM seem appropriate and directly address the fact this crisis unlike Japan’s Real Estate or the Use’s Internet bubble is global in scope and has seriously affected world credit markets including inter-bank lending.
This is a direct result of the deregulation and globalization of financial markets during the asses and the early part of this Century and that Glass-Steerage’s repeal meant investment banks particularly became major players in packaging and distributing these products globally along with related instruments such as credit default swaps.
Therefore in the medium term the Fed and other regulatory bodies need to examine ways to increase the transparency and decrease the leverage inherent in these uncial products and the institutions that create and distribute them, insisting on a greater appreciation and valuation of the related risks especially if the investment banks want and need greater access to central bank credit.
In addition the Congress and the Administration need to take measures to reduce the over-supply of housing and the possible cascading downward spiral of foreclosures and falling home prices that are seriously affecting the real economy including rising unemployment and a possible recession. Fiscal and monetary policy alone will not do the trick. There is lotions has already resulted in two large asset bubbles with adverse economic consequences. Therefore as already initiated by the Fed and the US Treasury there is a need to assess and develop regulations and policy responses to unwarranted asset inflation.