WHO SHOULD WE BLAME FOR THE HOUSING BUSTS?

Watching the press trying to sort out the financial mess reminds me of my dog chasing his tail. The Press is on a mission to find the “smoking gun.” If we could only find someone to blame, someone to vilify, it would make us all feel better. I have been pondering the blame game for sometime having found myself in the middle of the hurricane working for Bear Stearns, at the time the largest issuer of what is now referred to as “toxic waste”. But like the press, I’m just chasing my own tail. The answer is elusive.

I’m reminded of the police chief in the famous movie Casablanca when he tells his subordinates to “Round up the usual suspects”. So here they are. My apologies if I have left anyone worthy of blame off the list.

CHAIRMAN GREENSPAN: The press loves to find fault with Mr. Greenspan who was the Chairman of the Federal Reserve from 1987 to 2005. His critics claim that his loose monetary policy caused the housing bubble by putting cheap money in the system.
Yet there are several problems with this theory. First, it is hard to find fault with Mr. Greenspan’s policy of releasing liquidity into the market place after the high tech bubble went bust in early 2000, and the attacks on September 11, 2001. Without the additional liquidity the economy would have fallen into a deep recession. This is particularly true in the months after September 11 when markets virtually shut down and the economy was in shock.

Second, as Mr. Greenspan points out in his Wall Street Journal Op-Ed piece earlier this month, the Federal Reserve does not regulate long term interest rates which are highly correlated to mortgage rates. In fact, long term interest rates unlike the fed funds rate are regulated by market forces; namely supply and demand. The correlation between long term rates and short term rates is no longer statistically significant.

THE CHINESE: Mr. Greenspan plainly admits the strong correlation between low mortgage rates and home price appreciation. But what caused long term rates to stay low for so long even after the Fed began to raise short term rates in early 2004? Mr. Greenspan writes: “…the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990’s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.”

In other words, the Chinese flooded our domestic market with cheap goods and parked the resulting cash in long term treasury bonds, causing the longest bond rally in history. As bond prices run inverse to interest rates and Treasury Bonds are highly correlated to mortgage rates this fueled housing demand.

So then, should we blame the Chinese or the American Consumer?

THE CONSUMER: It was, after all, the American consumer who bought all that “made in China” stuff and in doing so helped (indirectly) pull down interest rates which propelled home prices. The home soon became a cash register as consumers piled on the home equity lines purchasing new cars, vacation homes and other trappings of material wealth. The average American soon believed that home prices would go up in perpetuity. People purchased homes they could not afford believing they could always sell later at a profit. When speculators arrived on the scene the market appreciation rates became surreal as the feeding frenzy began to take hold.

THE MORTGAGE LENDERS: Lax underwriting, poor quality control and straight up greed became epidemic as Lenders fought for market share in an ever increasingly competitive market. As one who developed business from Brokers for 25 years, I clearly saw the massive shift in the business practices of Lenders succumbing to the competitive landscape and pandering to Brokers and consumers alike. As I once told my sales force, it is as if we gave the keys to the Ferrari to a teenager. The 100% commissioned originator on the street simply had too much power.

THE MORTGAGE BROKER: Were there abuses? Of course there were. A handful of unscrupulous Brokers made the whole industry look bad. Because the Broker is a small business man without the lobbying resources of say, FNMA, he is vilified by politicians and the press. Moreover, the Broker has always been seen as an unwelcome competitor to big bank originators who, despite their resentment at having to compete with this low cost producer, dealt with him nonetheless to achieve the desired market share. It is important to point out that the Mortgage Brokers and the Mortgage Lenders did not develop the lending criteria used to make loans. These came from Wall Street.

WALL STREET: Now here is a group that the press is having fun with. Bear Stearns, Lehman Brothers, Merrill Lynch to name a few. These are truly the bad guys, right? It is not so simple. Remember we had gone through a period of unprecedented low rates as discussed earlier. The Institutional Investor was becoming frustrated with low yields on fixed income securities (aka Mortgage backed securities) and asked his favorite Investment Banker for help. “Can’t you get me something with a little better yield?” The guys at Bear Stearns were more than willing to help satisfy this demand with Mortgage Backed Securities collateralized with sub-prime loans, Collateralized Debt Obligations (CDO) and Credit default swaps, which all carried the promise of higher yield but also the associated risk.

These credit derivatives known as CDOs had the effect of putting a pile of horse dung in a big vat of rose pedals. As “The Economist” put it, It was a like the “Toddler at the pool-side syndrome.” The adults attending the pool party collectively thinks the other adult is watching. When the toddler falls in, no one is watching and the kid drowns. This is what happened to credit risk. Each party to the transaction thought it was the other guy’s job to manage risk. So then, where were the regulators? What happened to the guys like S&P who are supposed to rate these securities? It is important to point out that most of these Mortgage Backed Securities carried “AAA” ratings.

REGULATORS AND RATING AGENCIES: The horse dung hidden in the rose pedals (MBS tranches – sub-prime loans mixed in with A paper loans) were rated by the rating agencies who did not understand what they were looking at because the financial innovation and sophistication was beyond them. Much of the same goes for the regulators, SEC who regulates Investment Bankers and OCC that regulates Banks. The former should have noticed the obscene leverage ratios of the Investment Banks and the latter should have looked hard at credit risk. Mr. Greenspan mentions this in his Op-Ed piece:

“It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.”

So who do we blame for the housing crash and the resulting financial meltdown? The “usual suspects” all share some blame but still there is no definitive “smoking gun.” No one entity can take the rap for the whole debacle. It seems we were all swimming in the same pool, making lots of money and forgetting about the toddler at the pool side.

If you want to find the “smoking gun”, call it globalization: the rise of capitalism in the emerging economies, the advancement of technology and good old fashion greed. Yet I would argue that despite our recent difficulties Globalization lifts everyone’s tide. But that discussion is for another day...