The Weird and Unknown From the U.S. Credit Rating Downgrade

We learned in a big way during the 2008 financial crisis that what we don't know can really hurt us. That would still be true today, after S&P lowered America's credit rating from AAA to AA+. We also know that weird stuff happens when the financial markets get a tummy ache. They seem likely to be queasy from the downgrade when the markets open tomorrow. The weird and unknown may surface soon.

Complex Trading. Major banks and hedge funds frequently trade esoteric investments in multi-investment positions involving U.S. Treasuries as hedges or otherwise. Quite often, these market players embrace leverage in playing this game, since it boosts potential profits. The downgrade shouldn't have come as a complete surprise, since the rating agencies have been loudly frowning at the U.S. debt situation for several months now. But the downgrade's timing was uncertain and its impact uncertain. Complex trading positions may become unhinged for unanticipated reasons. These large institutional traders may find their positions exposed, or may receive unexpected demands for collateral from brokers or counterparties, and then struggle to keep things on an even keel. If so, that could prove unsettling for the markets, especially if the exposures from such trading are directly or indirectly concentrated in one or two companies, a la AIG circa 2008. The reform of the derivatives market has proceeded slowly, if at all, and regulators likely have no idea if there exists the potential for another meltdown. So all we can do is wait and see what happens. If there is another AIG lurking out there, expect very bad consequences.

Housing Market Hassles. Fannie Mae and Freddie Mac provide almost all the financing in the residential real estate markets, primarily because their debts are effectively 100% guaranteed by the U.S. government. It's logical to expect that Fannie and Freddie will be downgraded, since their sugar daddy was just downgraded. This could make mortgage loans harder to get. Not necessarily because interest rates would rise, because the U.S. Treasury downgrade could trigger a flight to safety that ironically would increase demand for U.S. Treasuries (there being few alternatives). But a Fan/Fred downgrade would make it harder to find investors for the mortgage backed securities that Fan/Fred backed loans go into. Investors in those securities are the true source of liquidity for the mortgage market, and may demand higher quality borrowers than current already stringent credit standards require. The housing market could slip on yet another banana peel in its path.

Chinese Communists Strengthened. China's Communist government has been coming under increasing domestic political pressure, because of rising unemployment, poor protection of consumers, sporadic protection of the environment, corruption and co-optation by China's capitalist plutocracy. The S&P downgrade of U.S. Treasuries, however, highlights the fundamental strength of the Chinese economy and its levitating currency, the yuan. That makes the Communist government look good, at a time when it needed some positive spin. Of course, S&P wasn't trying to influence internal Chinese politics. But the law of unintended consequences is the supreme authority in the world of finance.

Obama-Boehner in 2012? Increased factionalism in both political parties is stretching current party delineations close to the breaking point. The Republican Party is held hostage by a limited number of Tea Party ideologues. Respected mainstream conservative voices have labeled Tea Partiers "hobbits, " which, albeit an affront to hobbits, captures the fantastical quality of the thinking on the far right. At the same time, the fissure between President Obama and liberal Democrats has been outed. Emotions are red hot. Ralph Nader publicly, and likely others nonpublicly, predict a primaries challenge to President Obama next year. No one is naming names yet. The most obvious challenger, Secretary of State Hillary Clinton, has publicly said she isn't running for elective office again. Neither a liberal left agenda, nor a Tea Party-style conservative platform, will win the White House in 2012. Both Obama and Boehner know that. Their problems with their parties will increase, because the debt ceiling deal creates a bipartisan committee to squabble more about deficit reduction, giving all factions many opportunities for further raucousness. With so many shouting past each other instead of having a dialogue, the conditions for a realignment of parties are ripening. It's impossible that Obama and Boehner would actually team up to run in 2012. But the pressures for a functioning U.S. government come from powerful forces in the financial markets and the economy. We're no longer debating political philosophy or ideology over beer and pretzels or coffee and Danish. Lots of jobs, careers, wealth, and retirements are on the line. The will of the people is for a functioning government, and ambitious politicians will find a way to give them one. Current party alignments may be endangered.

Taboos of the Real Estate Crisis

Today's housing news was that contracts to purchase existing homes fell 7.6% in January from the December 2009 level. Last week, we learned that new home sales fell 11.2% to the lowest level ever recorded since 1963, when the Census Bureau began tracking new home sales. Clearly, in spite of an expanded buyer's tax credit, the housing market remains a sick puppy.

Relief measures have treated symptoms. Defaulting homeowners get opportunities to restructure their mortgages, but lasting success is infrequent. Homeowners who haven't defaulted have trouble getting relief, especially if they are underwater. Underwater homeowners are increasingly tempted to walk away from their mortgages, especially if the loans are nonrecourse.

Treating symptoms often doesn't cure illnesses. Dealing with underlying causes is usually more effective. But the underlying causes of the real estate crisis are taboo. They cannot be discussed openly, not by government officials, nor Wall Street bankers, nor real estate industry professionals, nor consumer advocates. Candor would reveal the intractability of the crisis. At the risk of offending everyone having anything to do with real estate, we offer a little candor.

The 30-year fixed rate mortgage doesn't make commercial sense. It is a difficult loan for banks to manage, since their costs (i.e., the interest expense of deposits and other borrowings) fluctuate while the rate on the mortgage remains fixed for a very long time. Before the 1930s, the 30-year mortgage didn't exist. For all practical purposes, it wouldn't exist today except that, since the Great Depression, the government has promoted it as a way to make home ownership affordable. We can't get away from it, because real estate values would probably take a great fall without its easy terms. Even today's shorter term adjustable rate loans have amortization schedules that contemplate a long term loan of 30 or sometimes more years, so they're really just an elaboration on the 30-year fixed rate.

Banks don't like to hold 30-year mortgages. These loans can be made only by mismatching a bank's shorter term liabilities (like deposits) against a long term fixed rate asset. This mismatch is a formula for lending disaster when short term rates exceed long term rates, and they have periodically, going back to the 1970s. That's why the secondary mortgage market grew so large, first through federal agencies like Fannie Mae, Freddie Mac and Ginnie Mae, and later through private sector innovations like the mortgage-backed security, the CDO, the CDO squared, and so on. Banks became accustomed to offloading their mortgage risks. But the securitization market blew up along with the real estate crisis and remains moribund. Banks haven't been able to adapt to a world without securitization. Mortgage loans are almost entirely unavailable except when they can be guaranteed by Fannie Mae, Freddie Mac, or another federal agency, and resold. Securitization is now a federal program, not a commercial market.

The government and many others continue to believe that if home ownership is good, more home ownership is better. While this argument might make some abstract sense in a middle school civics class, reality is that home ownership in America usually requires credit. Even if some level of home ownership acquired with credit is good, that doesn't make more credit-fueled home ownership better. Only so many people are good bets for mortgage loans, and after that borrowers become riskier. We found that out the hard way in the 2000s, when defaults by the risky borrowers drove down home prices. In a society where home ownership is largely based on credit, there is an optimal level of home ownership, and after that it's a bad idea. However, not one policymaker in a trillion will openly endorse this point.

Another taboo is the proposition that banks should book the full extent of their home loan lending losses. America's banking system continues to hold hundreds of billions of dollars of losses attributable to home financing. Booking these losses would require more embarrassment on the part of banks (along with more capital raising efforts), more official consternation over the stability of the financial system and kabuki outrage over banker bonuses, and more houses in foreclosure sales pressuring prices downward. But not booking them is clogging up the banking system. Banks are afraid to lend because they want to hold onto their cash as a reserve against these unbooked losses. The paucity of bank credit is a crucial reason why the economic recovery is so tenuous. Economic stagnation is likely with the banking system in neutral.

So the wheels spin, caught in the muck of mortgages that don't make commercial sense, a secondary mortgage market that doesn't function except as a government program, the assumption that we need to make more, and then even more, bad mortgage loans in order to advance the goal of home ownership, and the unwillingness of banks and their regulators to fully face up to the losses of the mortgage mess. There's hardly any room for market forces to operate--and that's why they hardly do. Housing isn't a market. It's a government program. It's kept on life support by government subsidies, and can't be weaned off of them because the price collapse that would follow would bankrupt America's middle class.

Perhaps over the next ten years, the housing market will gradually revive. But it will surely continue to be built on the precarious edifice of taboos. Too much of America's capital will be misdirected into housing. Government borrowings will absorb vast amounts of what's left. Manufacturing and other activities fundamental to economic strength will be left with scraps. Growth will be stunted. Americans will squabble over who pays for health care, Social Security and other obligations that seem overwhelming when a slow growing economy doesn't produce wealth commensurate with society's generosity. But taboos cannot be discussed, so we end this essay. Good luck.

The Donkey-Backwards Housing Finance Debate

One of the biggest questions in housing finance is how to revive the securitization market. During the housing boom of the early 2000s, banks earned massive amounts of fee and commission income by packaging mortgages into mortgage-backed securities. These securities were often sliced and diced into CDOs, CDOs squared and what not, in order to further entice investors (and speculators). What happened next is all too well known. The banks, eager to bulk up low-risk fee revenue while offloading lending risk, thought that if writing a lot of mortgage loans was good, then writing a shipload more would be even better. Lending standards dropped, to the point where banks didn't always document borrowers' incomes, as if to avoid learning that they shouldn't extend the loan. There were plenty of times when they shouldn't have, but did anyway.

That insouciance toward prudence dug a very deep grave for investor interest in securitized loans. Today, just about the only mortgage-backed securities that can be sold carry explicit U.S. government guarantees. Housing finance has become a federal program, and today's housing stock enjoys what is effectively a federal price support policy.

Needless to say, taxpayers can't support housing values indefinitely. In the view of bankers and many regulators, securitization must be improved and revived. The two potential improvements most often discussed are (a) requiring the banks that package mortgages to keep some of the lending risk, or (b) improving underwriting standards without requiring underwriting banks to keep some "skin in the game." The first concept is intended to keep the banks honest. But banks holding increased amounts of lending risk also must increase their capital levels. That is likely to lower profits, anathema to their executives suites and also not to the liking of some bank regulators, who seem to equate lower bank profits with greater aggravations for themselves. The second notion--improved underwriting standards--is clearly necessary, but insufficient by itself. Investors aren't prepared to put down their money with just promises of improvement.

The problem is the discussion focuses on what the banks (and regulators) want, not what investors would like. This is donkey-backwards. A revival of a private securitization market depends on the willingness of investors to plunk their cash onto the barrelhead. There used to be a notion in American business that the customer is always right. A little fillip of customer service--i.e., investor protection--needs to be added to the mix.

First, there's the issue of trust. Trust is the true foundation of the financial system. Investors no longer trust the banks at the heart of the securitization process. That's why the only mortgage-backed securities acceptable to investors today bear a federal guarantee. Banks hoping to securitize on their own seem to be viewed as little more than potential scofflaws. Serious regulatory reform--of both banking and the derivatives market--is essential. Consumer protection must be greatly strengthened, lending standards bearing a reasonable resemblance to prudence have to be enforced, and the derivatives market must become much more transparent. But the scope of reform evolving in current legislative proposals may be inadequate to reassure holders of capital.

Second, the securitization market as it existed in the early 2000s ceased to be risk-sensitive. Investors had no effective way to discern that they were buying bags of digestive waste, and banks securitizing loans ceased to care that they were selling the same. The absence of risk sensitivity created grotesque market distortions that resulted in millions of bad loans being made, which may have enriched underwriting banks but also led to the defaults and foreclosures that have been driving down real estate prices.

Risk insensitivity is the problem that the skin-in-the-game requirement is intended to fix. The continued desertification of the securitization market is a signal that not enough is being done. Further product development is required. Perhaps banks should agree to limit investor losses to a predetermined number of cents on the dollar invested. After that, the underwriting bank would bear all losses. The less the investment resembles a pig in a poke, the more likely people will buy. Such a provision would improve the quality of mortgages in the pool, which would benefit investors--and homeowners. Fewer low quality loans would be made. Even if home ownership levels fall, bad loans do not, in the medium (let alone, long) term, increase home ownership. They do, however, drive down real estate values when borrowers default and end up in foreclosure.

Another improvement would be for banks to open up their databases concerning the underlying mortgages to credit rating agencies, and indeed, investors, for analysis. People are more likely to buy if they can kick the tires and lift up the hood. Any competitive issues would be unimportant if all offerings are subject to inspection. Of course, this may make pricing more accurate, or, stated otherwise, fairer to investors. And that's the idea. People will pay a fair price for what they understand, but not a penny for the opaque, black box CDOs of yore. Bank profits would be lower. But the current miserly dialogue about minimizing the extent of improvements to the securitization process may be holding down underwriting banks' costs, at the expense of expunging investor interest.

The bank-centric orientation of reforming the securitization market isn't even leading investors to water, let alone inducing them to drink. However, if banks and regulators would give a nod to the holders of capital who've been taking it on the chin for the last few years, maybe they'd see the phoenix rise from the ashes.