Propping up the US financial system as it begins to cave in


The masters of the universe are looking decidedly less masterly these days, though they still have much more wealth than you and I. Tom Wolfe coined the phrase “masters of the universe” for gun-slinging Wall Street bond traders some two decades ago, in his satirical novel Bonfire of the Vanities.
Little did he imagine how far financial engineering would overreach and how much damage could occur to the real economy from unbridled greed and risk-taking with other people’s money. Although it does all read like a morality tale, with many villains to be exposed and shamed, there is also a need to predict how it will turn out, and that is not as easy to do.

The latest episodes in the saga of the global financial system really do resemble the collapse of a house of cards. Ordinary home loans re-packaged into securities were a questionable idea in the first place.
The problem is that securitisation removed the incentive on the mortgage broker originating, or underwriting, the loan to ensure an extremely high probability that the loan interest and principal would be paid. On top of that, Wall Street piled such lucrative fees to themselves for bundling loans into securities that they induced mortgage brokers to round up anyone they could find to borrow.
As a result, the loan growth from 2005 to 2007 was largely in loans to unfit borrowers, sub-prime and similar, or with unsuitable collateral, or both. We won’t even delve into the structured paper that chops up the first and last parts of the default risk on the home loans. If all that were not enough folly, the likes of Carlyle Capital and other hedge funds ran out to borrow vast amounts of cheap money from the big banks with which to buy these mortgage-backed securities.
Carlyle Capital borrowed $20 for every dollar of its equity capital, leaving almost no margin for error. It looked like a fun sport at the time, when they could pocket the spread between the low bank interest they were paying and the higher yield they received on

the securities.

So now household borrowers are defaulting at record rates on the home loans that support these securities. The debt binge stoked an unsustainable run-up in US house prices and a housing glut, so the homes, which are the collateral backing the loans, are worth less than the mortgage principal in all too many cases. Now nobody wants to own these mortgage-backed securities since it is unclear how much the mortgages will pay back. As these securities’ market value drops, the banks that lent money to Carlyle and others want that money back. Carlyle Capital could not or would not come up with more capital this week. The billionaire chiefs of the hedge fund’s parent, the Carlyle Group, apparently concluded helping out their brainchild would be throwing good money after bad. So the banks took control of the fund’s assets and started selling them off. In a market where everybody is afraid to buy, that merely causes the prices of these securities to plummet. By pulling the first card,

the banks seemingly ensure that the whole house topples.

The Federal Reserve is trying to catch the cards and prop them back up, however. For it has provided massive loans to the banks, with few questions asked. The Fed probably hoped this action would help the banks not to panic and pull the collateral card from under the hedge funds. This week the Fed took a more direct line, offering to accept mortgage-backed paper from prime brokers and let them have rock-solid Treasuries instead.
The Fed more or less became the buyer of last resort of debt, that the private market could no longer value. This means that the US taxpayer could be stuck with the bill if the securities which the Fed is accepting turn out in the long run to be worth less than the amount the Fed effectively paid for them. That is a bailout by any other name. Luckily for the financiers, this situation has become too complicated for all but a few to follow. Taxpayers cannot become irate if they don’t know what hit them.

In any case, the Fed would argue that it is making the best of a bad job. If it succeeds in preventing or reducing panic in the loan markets, there are big benefits to the real economy. Put the other way, if even quite sound loans become impossible to finance, then credit-worthy borrowers are going to be unable to get a mortgage to buy a house they could normally easily afford. House prices would drop precipitously in that case, making the current parlous state of the housing market look like a picnic.
The wealth effect would be horrible as every American would be uncomfortably aware of taking a haircut on the equity in their homes. Families would not be able to move, which they often do to take jobs, and that would hurt the labour market. This kind of calamity would probably be short-lived because it is as unreasonable as the bubble that we have just suffered. But why go through such a crisis if it can be avoided?

The Fed is not alone in trying to prop up the cards as they fall. Treasury Secretary Hank Paulson has belatedly become convinced we need some standards and oversight for mortgage brokers, to put an end to such egregious practices as liar loans, where people were encouraged to lie about their incomes in order to qualify.
It seems only yesterday that Paulson and two Fed chairmen were assuring us the market worked perfectly and regulation would destroy wealth and keep people from owning homes. How times change when the cards are falling.
The Secretary also is calling on the big banks to preserve capital by cutting their dividend payouts. Again, so much for the glories of free markets. He seems to have come round to the realisation intervention is essential, and that the ordinary citizen cannot be expected to tolerate such rescues unless the beneficiaries are forced to mend their ways.

So can this house of cards be propped back up? If so, how? If not, how bad does the US economy get?

Since a housing glut underlies the crisis, it would still help if lenders were prevented from foreclosing on homes. It would also help if the lender wrote off principal where house prices have dropped well below the mortgage amounts. Sure, this interferes with private contracts. Yet in many cases broker sharp practices made the contracts morally illegitimate, if not legally so. And in any case, the privately owned players in the financial system have no contract with the taxpayers requiring a bailout. Once the Fed has to step in to buy assets that nobody else will buy, it should be able to call the shots on the taxpayers’ behalf. 

The reality is that it is in the collective interest of lenders to avoid a foreclosure and jingle-mail wave that guts the value of homes much more than has already occurred. If hundreds of thousands of homeowners are kicked out of their houses or quit because it is not worth their while to continue paying their mortgages back, they are also subtracted from the demand side of the house market. There are already way more houses available than people with the credit to buy them. 

But individual lenders will tend to pull the trigger on individual loans that are in default. They are stuck in a kind of prisoner’s dilemma, where they cannot control other lenders’ behaviour and have to shift for themselves as best they can. Adult supervision is required to prevent this collective effect of lenders taking a myopic view.
Several ideas for a moratorium on mortgage foreclosures are still in front of Congress. It remains to be seen whether the furious opposition of the bankers will abate as they either see the folly of their position or are pressured into acquiescence by the Fed, on whom they depend for their very existence. Another change that might help would be to give people who are considering defaulting reason to pause. Word has gone around that you can declare bankruptcy, mail in your house keys to the bank, and then be back with a new home loan in as little as three years.
There has to be a stronger incentive for borrowers to act responsibly, such as a rule that bankrupts cannot obtain home loans again within 10 years of their last failure. It is just not clear if any action will be taken fast enough to help the housing market.

Even if sanity prevails on foreclosures soon enough to make a difference, house prices almost certainly have a long way further to drop to bring them into line with what families can afford on their incomes. That means there is good reason for a lot of these mortgage-backed securities to have lost value. Whether the recent plunges are overdone or are merely appropriate re-pricing is difficult to tell. If the asset-backed securities do not recover in price, then more hedge funds, banks and insurers with portfolios containing them are headed for trouble. Credit will become very tight and bank failures will occur. This is sure to be highly disruptive to the real economy. Although corporate balance sheets are supposed to be in strong shape because of years of record profits, there are plenty of companies that could use access to debt.

Nobody has a model of how this will all work through. But I will note that since I wrote recently that this is looking like the worst financial crisis since the Great Depression, I have noticed other economic commentators starting to adopt similar language.

Policy-makers should have taken Tom Wolfe’s satire on the masters of the universe seriously. The go-go activity of an under-regulated financial sector always ends in disaster for everyone except for the clever few who get their fees and bonuses out before the house of cards collapses.