WHAT WENT WRONG
WALL STREET and
the REAL ESTATE INDUSTRY?
I. Nelson, Ph.D.
20 October 2008
This 2008 article says the debt is enormous and the TARP bailout is justified.
later 2010 article says it was willful fraud, the Fed is printing
trillions to hide it, and I was naive to fall for TARP.
The 2010 article is, "The Federal Reserve is Printing Money".
"The Fed was really adamantly opposed to any form of regulation whatsoever."
--Arthur Levitt Jr., Chairman, Securities and Exchange Commission (SEC), 1993-2001
quoted in Washington Post, 15Oct08, pg A9
"... the burst of the biggest credit bubble in history ... "
The Washington Post, 24Jan09, pg A1
The white elites in banking destroyed their own industry.
people must step forward to fix it. This means you. Writing
this helped me sort out the pieces. You can do it too.
Take it apart, examine the
pieces, don't let them do it again.
collapse arises from the unwillingness of anyone with some capital to
lend it to anyone else. This brings investment and economic
growth -- as well as short-term business operations -- to a
halt. It is noteworthy that banks and other financial
institutions have money, but are afraid to lend it because the
financial strength of partners can not be ascertained from balance
sheet statements. The damage is sufficiently broad
geographically, widespread across elements of the finance industry, and
deep psychologically to guarantee a world-wide recession lasting at
least a year. IMHO, the response of the world's leaders and
ruling elites has thus far (20Oct08) been sufficiently piecemeal,
inconsistent and even wrong to guarantee great delays in recovery.
broad terms, the last American Chairman of the Federal Reserve, Alan
Greenspan, permitted lax enough monetary policies to support rather
than contain two bubbles, one in Internet and telecommunications
(fiber) investment which lasted until 2001, and another in housing,
which lasted until now. The privatization of social security would have been the third.
quasi-governmental status of the Federal National Mortgage Association
(ticker FNMA, Fannie Mae) and the Federal Home Loan Mortgage
Corporation (FRE, Freddie Mac) enabled them to draw capital into the
housing industry more easily. They were trusted.
and Freddie Mac drove a mortgage carousel. Money was lent,
came back, and was lent again. Soon mortgage originators were
scraping the bottom of the barrel for new customers. The
proportion of subprime mortgages more than doubled,
from less than 10% of all mortgages to more than a fifth.
The carousel turned. Then Federal Reserve monetary
policies piled the carousel ever higher with cash. The result
was that the United States consumed a great proportion of its
manufacturing capacity in the unproductive creation of
housing. In the five years between 2002 and 2007, the number of
homes that sold for over $1 million more than tripled to 64,300.
Not far from where I live "inside the beltway" in
the metropolitan Washington DC area, you may see houses like
click photo to enlarge
Some houses in The Reserve, McLean, marked with red dots.
In the Washington DC area, small government means big houses.
in the Spring of 2008, this home on Balls Hill Road, McLean, VA, went
on our local housing market at $17.5 million.
To look up the map yourself, just enter
McLean, VA 22102
Google, and ask to see the map you will be offered. Look
around the neighborhood, which is much larger than the few blocks with
50+ homes marked here. Since the photo was made, houses have
been built all along "Founder's Ridge" . Although there are
some mansions at $7 million, the neighborhood has a fairly uniform look
and feel. Most homes are between $3 and $5 million and
look like the street below.
click photo to enlarge
Three homes around a cozy
cull-de-sac in The Reserve of McLean, VA 22102
your money, take it back ! " Fine, but then where does it go?
in the National Capital metropolitan area, special factors drive the
housing market. The attack on civic government by the
Republican Party ("It's your money, take it back") has hollowed out
public service. Services must still be performed, but now
private corporations handle them. The few civil servants
remaining in public service often lack the expertise, let alone
the authority, to monitor private contractors feeding on public
In the suburbs of the nation's capital, "small government" means big houses.
the country as a whole, the monetary policies that supported the
dot.com boom and bust also enabled the housing boom and bust.
In housing, those funds could be recycled with ever-faster turns of
the money carousel. Those recycling mechanisms, and the
mortgages themselves, need to be appreciated to understand how the
enterprise could spiral into a pile of financial instruments
with a multi-trillion dollar face value. The true value was much
less, which doomed the bubble to burst. But how much less was
not knowable, which added the elements of mistrust and fear, and
**that** is what froze the banks and sank the stock market.
Let's start with the mortgages.
financial collapse has at its roots the fraudulent application for
mortgages. Applications falsely stated such things as the
applicant's employment status, income, credit rating and credit
history. Mortgage terms were constructed to be both
compelling for deal closure and conducive to
terms conducive to closing the deal include no money down, low interest
rates, unwarranted promises about cashing out at any time by easily
selling the house if one could no longer carry the
obligation. Selling mortgages with excessively conducive
terms is called "predatory lending." Mortgage terms conducive
to failure include lending to someone with little income in the first
place to support the payments and ballooning interest rates
rather than fixed ones. Who
was stupid and who should now take responsibility for her actions, the
lender or the borrower?
Predatory lending with :"sucker rate" balloon mortgages targeted poorer
people as Fannie Mae, Freddie Mac and the rest of the mortgage lending
industry went down-market into virgin territory where people did
not already own homes. But there will be foreclosures among the
million-dollar homes that grace my neighborhood and this Web page.
By August 2008, 7,968 homes that had sold for over one
million dollars were already in foreclosure nationwide. We all
await the first tear-down that replaces one with something smaller and
So was it the
lenders fault or the borrowers? Blame doesn't matter if you are
looking for social policies that got us here, that must be changed to
get us out again. The
mortgages were sold because the sellers were paid to sell
them. Bad policy. But then free-lancing mortgage brokers
sold a mortgage
again. And again. How was this possible? Beyond
policies to reward an individual's bad behavior loom structural
problems in society as a whole: the money machines.
IN MORE MONEY, DO IT AGAIN
Today we securitize bundles of mortgages and to sell
them as securities, bonds or other financial instruments (e.g.,
collateralized debt obligations). People who sold these
financial instruments earned a commission on each sale and were
incentivized to invent more ways of reselling mortgages. They
invented and sold new instruments. They turned to a wider
spectrum of investors in many countries and outside the real estate
mortgages have a higher interest rate than large commercial loans to
corporations, much higher than government loans (Treasury
bonds). Mortgages repackaged as bonds paid a higher return
than other bonds. Banks investing in them could offer higher
savings interest. Mutual fund managers could expect higher
returns. The returns offered to pension fund and college
trust fund managers (professional investors) were higher than other
investments. When new customers bought the new forms of debt
(new ways to repackage bundles of mortgages), their money financed the
creation and sale of yet another round of
mortgages. The mortgage carousel turned. New home buyers had to be found.
these players bought the rights to participate in the money stream from
homeowners paying their monthly mortgage. The players'
(investors') money returned to Main Street in Everytown,
where freelance brokers beat the pavement looking for people
who still did not own a mortgaged home. Good companies
involved in the housing mortgage industries had to lose their market,
had to lose business, unless they joined their "live-for-the-day"
competitors in a race to the bottom. People at the bottom are
sub-prime credit risks and their homes are purchased with "sub-prime
mortgages". Often they were even worse than this: they did
not qualify for **any** mortgage, and their application was
carousel turned. Each person on every horse collected his
AGENCIES OF PUBLIC POLICY
policy to create securitized mortgages and the creation of
semi-public institutions to run the securitization process is rooted in
public policy to provide everyone with his own home. The
agencies that ran large securitization operations were Fannie
Mae and Freddie Mac, the Federal National Mortgage
Association (FNMA) and Federal Home Loan Mortgage Corporation
Mae and Freddie Mac (the latter with more than four large headquarters
buildings in McLean, VA) sped the carousel by running
enormous server farms and databases to keep track of all the mortgages.
They increased the weight of money on the carousel by attracting
investors in remote industries and far away countries with the
appearance of government backing.
databases on every mortgage and the government-sponsored status
provided a feeling of safety to the buyers of bundles of
mortgages. It seemed possible to check the safety of the home
payment money stream by drilling down to the details of any particular
mortgage, or to scan millions of them to pull out normative
averages. It seemed the government might treat
Fannie and Freddie as "too big to fail". The investments
seemed safe and they were bought, repackaged, and bought
Freddie Mac's five HQ buildings in McLean. Large server farms
and storage arrays hold data on all of the mortgages backed by Freddie
Mac ("conforming loans"), and most of the bundled mortgages bought and
traded by them from other players in the "secondary" (securitized)
AND UNREGULATED DEBT INSTRUMENTS
brokers and small banks have to bundle and sell their mortgages in
order to receive the funds that turn the housing carousel one more
time. The bundles were often first "securitized' as bonds.
Larger players could buy the bonds and earn a commission
repackaging and reselling them as another
instrument, perhaps a collateralized debt obligation (CDO). CDOs
were divided into
secure, middling and risky but high-interest "tranches" that sounded
orderly and secure.
Those more sophisticated financial instruments were resold to larger or
more sophisticated customers.
financial industry was incentivized to invent ever more debt
instruments which were more remote -- more highly "derived" -- from the
underlying asset; namely, your neighbor paying her monthly mortgage. The invented financial instruments grew ever more
collateralized debt obligations are complex, many people are needed to
create and sell them. Each earns a fee: the
Underwriter, the Asset Manager, Accountants, Attorneys, and the Trustee
and Collateral Administrator (e.g., Freddie Mac, maintaining
the mortgage data bases).
creativity of financial institutions -- creating more "product" -- was
rewarded by added fees and evaded regulation. This is not
"greed and corruption" in Wall Street. This is creativity in
making use of the framework -- the corporate playing field -- that was
handed to the industry.
argued that ... skewed incentives ... had almost guaranteed the
eventual crackup. Mortgage companies had offered dubious subprime
mortgages, for a fee; investment banks had turned them into exotic
securities, for a fee; rating agencies had given them artificially high
marks, for a fee. The system 'worked,' you might say."
--David Ignatius, Washington Post 1Feb09 pg B7, after attending and chairing discussions at Davos.
World Economic Forum at Davos, Switzerland is a CEO club attended this
year also by the Chinese Premier (Win Jiabao), the Russian kingpin and
Prime Minister (Vladimir Putin), and other, mostly European, political
most visible of the gaps in existing regulations is the $55 trillion
notional [hidden] market in credit default swaps. ... Just as important
as improved regulation in these areas is transparency for investors.
Transparent markets require less outside intervention because
investors can make rational decisions."
-- Christopher Cox, current Chairman, Securities and Exchange
Commission, writing in the Washington Post, 4Nov08 pg A17. Cox
was nominated by G.W. Bush and confirmed in June, 2005.
will mention only one other higher form of financial instrument, the
credit swap. Credit swaps could be written against a variety
of different events, such as the default of a large financial borrower.
That would be a credit **default** swap. The word is
probably unfamiliar to you, and that's the whole point, as this quote
staff member of the Commodity Futures Trading Commission, Michael
Greenberger describes a credit swap in brief: 'A credit default swap is
a contract between two people, one of whom is giving insurance to the
other that he will be paid in the event that a financial institution,
or a financial instrument, fails. It is an insurance contract, but
they've been very careful not to call it that because if it were
insurance, it would be regulated. So they use a magic substitute word
called a 'swap,' which by virtue of federal law is deregulated.'" http://en.wikipedia.org/wiki/Credit_default_swap
default swaps were created (invented) ca. 1998, only about 10 years
ago, but today provide insurance for at least $35 trillion of loan
agreements, based on contracts held on behalf of their may clients by
the Depository Trust and Clearing Corporation. If we imagine
hypothetically an insurance commission of 1/10th of one percent on a
premium value of $35 trillion, the invention of credit default swaps
means the invention of a new revenue stream worth $35 billion
dollars. It was a great party while it lasted.
national government loaned the insurance company American International
Group (AIG) $85 billion on 16 September 2008, in part to cover AIG's
credit default swap insurance policies on companies that were indeed
defaulting on their loans. The Federal Reserve made another
$37.8B available to AIG on 9 October. Will this be enough?
On 30 November, $20B more was made available to AIG from the
"commercial paper bailout fund." Will **this**be enough?
Depository Trust and Clearing Corporation computer servers hold
complete contract information for the credit default swaps of its
clients. But those $35 trillion in obligations are not the
limits of the complete credit default swap industry, which a derivative
industry group pegs at $55 trillion. A 10 or 20 trillion
dollar uncertainty in how much debt is insured and how much a full and
effective bailout would cost cannot be resolved, because financial
firms are not required to list "swaps" on their balance
sheets. Besides rendering the industry partially invisible,
lack of visibility on balance sheets causes trading partners to grow
too suspicious and fearful of one another to do business together (to
free markets have good visibility but this one does not.
Indeed, there is no open market in derivatives of any kind --
they are traded on no public exchange. The global market for
derivatives of all kinds was over $530 trillion as of mid-2008.
Compare the value of all stocks listed on the New York
Stock Exchange (NYSE), which was $30 trillion before the
current collapse. . A "dark market" 17 times the size of
the NYSE is in the hands of professionals whom we should trust, says Allen Greenspan:
"Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary. And
participants in financial futures markets are predominantly
professionals that simply do not require the customer protections that
may be needed by the general public. ... Regulation that serves
no useful purpose hinders the efficiency of markets to enlarge
standards of living. " Allen Greenspan
(Chairman, Federal Reserve, 1987-2006) (Congressional testimony, 1998).
are a good thing. If you want to come to the eBay market, you had
better have a good feedback rating. If you screw up once in a while, be
responsible and take care of your customer -- protect your rating or
lose your ability to list. eBay also makes some effort to set
aside some of their earnings in a reserve to complete deals that
get broken -- buyers who never pay, sellers who don't deliver.
Getting all transactions completed (cleared out of the marketplace)
makes for a more orderly auction market. eBay says, If you want
to trade, we have the most active market. Come to us, but play by
a few rules that we all follow here.
We all understand eBay. We can all demand the same for
derivatives. We can all say, " If you want to list, play by a few
simple rules. We'll give you a market that is open like
eBay, that has a clearing house to keep the market orderly by
clearing out deals that get broken. But it will be pay to play.
You derivative holders have to maintain certain
publicly-disclosed (transparent) cash levels so that you can deliver on
your own promises most of the time. The days of hundred billion
dollar bailouts are over. It's not 2008 anymore."
because they are complex does not mean you cannot raise your voice
against credit default swaps. If you majored in English and
don't know economics, you can still say, "Let's call these CDS's 'default insurance'. That's what they are." We can
all still say, "Put more information on your balance sheets.
List the swaps."
Transparency attracts investment, and we
need the money.
HOUSE OF CARDS
house of cards is now complete.
Mortgages have been resold as bundles, re-created and resold so many
times that houses that should not have been built have now been sold to
people who should not have bought them. The mortgage carousel
Many sources of money (pension funds, college endowments) have been
tapped in many countries around the world to give Americans a standard
of living they could only attain on borrowed wealth.
Instruments of little transparency and no regulation have been created
by the financial services industry. The new instruments earn
fees for many but can be understood by few. This lays a
foundation for mistrust among thousands of financial institutions,
including the largest ones in the country, who cannot judge the
strength of any potential lending partner's balance sheet.
The value of the collateral of collateralized debt obligations worth
over $35 trillion dollars can be surveyed by computer, but many data
on mortgage holders prove to be fraudulent. "Garbage in, garbage out," as
computer people say.
collapse of the house of cards cannot be fixed by spending $700 billion
dollars on a bail-out (plus $250 billion in pork handed out to buy
votes to pass the bailout legislation) because structural problems not
corrected by money exist and undermine trust.
PROBLEM WILL LAST
problem will last because it has psychological and structural
dimensions not addressed by handing out money.
money being handed out to lenders is saving institutions that should
fail as management and business entities. There is
toxic debt that cannot be valued because of complexity, and that
complexity is seen to hide underlying fraud when it is peeled
away. Money handed out to save banks that should fail does
not remove toxic debt that poisons the system.
handed out to creditors (the financial institutions, the mortgage
recycling carousel operators, the inventors of lucrative but hidden
financial instruments) does not help borrowers. Borrowers are
the millions of homeowners who cannot go shopping to rescue the economy
after being dumped on the sidewalk with their furniture.
This, too, will have its psychological dimensions of fear and mistrust
that can prolong our mutually shared downward journey.
Failure to aid debtors will reap fear and economic paralysis as surely
as fear and mistrust among the banker classes has stopped their
financial solutions -- those proposed for lenders, those yet to be
proposed for borrowers -- can solve the structural problems in the
housing and financial industries which incentivized bad behavior,
encouraged financial arrangements burdened with opacity and doubt
instead of transparency and trust, and which failed to recognize
eternals of human behavior, such as deception in the pursuit of
self-interest. Regulations that were dismantled or
sidestepped need to be replaced by ones that are not.
are many policy issues to focus on and to formulate beyond merely
injecting $700 billion into the banking system. In the waning
days of a right-leaning Administration, seven hundred billion dollars
is being transferred mostly from working-class citizens into the hands
of the ruling elite. Yet the nation's top legislative body
did not address any of the major policy issues now hanging fire.
Instead, it spent a week bribing itself with $250 billion to
get the votes to hand itself $700 billion to help a minority of the
country's citizens. This does not bode well for the depth of
the economic depression the world now faces at the hands of failed
I dedicate this essay to
Columbia Partners Investment Management and to all the creative and
quantitative professionals I met there. People who manage the
investment of pension funds and wealthy clients' assets depend on the
honesty and transparency of the market just as anyone else does.
Investment and portfolio management is the bright, silver lining in a now
top of this 2 yrs later - the 2010 article politics area generally home page of everything
20October2008 Rev4NovCox+AIG$ Rev24Jan09WPostWorstBubbleQuote
Rev 27Jan09DedicationToBlacks 1Feb09AddIgnatiusQuote
Rev 1May10 Shorten dedication, add foreclosure photo
Rev 23Oct10 Better estimate of total mortgage value: 11 trillion dollars