From Bad Loans to Bailout

The US financial crisis rolls on. On Wednesday night, President George W. Bush gave a speech in which he said "the entire economy is in danger." As debate rages in the US and here in Australia on the merits of the US$700 billion bailout package proposed by US Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke, attention has also turned to the origins of the current crisis.

The Paulson-Bernanke bailout will represent one of the largest ever government interventions in the US economy (although Richard Nixon’s wage and price-fixing regulations of 1971 were probably bigger). Its announcement initially calmed financial markets before doubts began to emerge on Tuesday.

The markets have consequently yo-yoed, as the massive losses of last week were replaced by massive gains on Friday and Monday, followed by cautious trading in recent days. The result leaves financial markets in Australia, the US and UK still well and truly in bear market territory — more than 25 per cent below their peak.

Paulson’s package was feverishly prepared during the dramatic closing stages of last week and was presented to US Congressional leaders on the weekend. It is a remarkable document.

Despite being less than three pages long, it proposes that Paulson be authorised to spend no less than US$700 billion on essentially whatever he wants — not just bad loans and dodgy mortgage-backed securities, but "other assets, as deemed necessary to effectively stabilise financial markets". Further, "the timing and scale of any purchases will be at the discretion of Treasury and its agents."

As prominent economist Nouriel Roubini told Bloomberg, "He’s asking for a huge amount of power. He’s saying, ‘Trust me, I’m going to do it right if you give me absolute control’."

It’s not surprising that financial markets are now becoming worried about the likelihood of this bill passing US Congress quickly. Indeed, Paulson’s plan has enraged liberals and conservatives alike.

Democrats and liberals want the bill to include curbs on executive salaries, on the not-unreasonable principle that the US Government should not seek to reward the very men responsible for the crisis in the first place. "This plan cannot be a welfare program for Wall Street executives," Barack Obama said at a news conference yesterday.

Conservatives, meanwhile, have railed against the socialist overtones of a package which essentially nationalises huge swathes of privately issued debt.

Free market evangelist Peter Schiff, President of Euro Pacific Capital in Connecticut, told ABC radio’s PM program on Tuesday, "I think what we’re doing is the equivalent of selling our financial souls to the devil, because it was the government that got us into this mess."

Schiff believes that, yes, leaving the mess for the markets to sort out would have had disastrous effects, but that the bailout is going to have even worse consequences down the track, at least for the US economy.

In many ways, the bailout plan is a textbook example of Naomi Klein’s "shock doctrine thesis". As Australian economist Nick Gruen pointed out on Wednesday, "while it might well have been necessary for something to be done, this something comes from the very worst tradition of Wall Street capitalising its profits and socialising its losses."

If the cure is this bad, just how bad is the illness?

Really bad. Everyone agrees that some kind of bold action was necessary to arrest the crisis in the financial markets.

Crisis is certainly not too serious a word for the situation on Thursday afternoon last week, when the forward international currency exchange markets completely ceased. US dollars could not be exchanged, because panicked banks everywhere in the world were not prepared to lend them. The international finance system really was just moments from apocalypse. If it had been allowed to continue, there is every chance that massive banks all over the world would have failed.

As I asked in my article about the fall of Lehman Brothers last week: how did it come to this?

Surprisingly easily. In this article, I’ll examine the origins of the subprime crisis. It turns out the origins of the current crisis can be traced back to the mid-1990s and a little known credit rating agency: the Fair Isaacs Corporation.

Sociologist of finance Martha Poon has traced the subprime crisis back to its roots in a prize-winning paper entitled "From New Deal Institutions to Capital Markets". The mechanisms of the lending spree that started it all can be found in the implementation by the US mortgage industry of a new credit score system, called the FICO. Developed by the Fair Isaac Corporation in the 1950s, the FICO score "numerically tags an estimated 75 per cent of the US population eligible for consumer credit on a linear scale of 300-850 units." Actually a series of three different scores from a number of different credit rating agencies, FICO scores were one of the first and most successful numerical credit score systems. They played a useful but low-key role in the US finance system for three decades.

All this changed in the mid-1990s, when the giant Federal Home Loan Mortgage Corporation — also known as Freddie Mac — began to use the FICO score as its main tool for screening home mortgages. Freddie Mac drew a credit-worthiness line at 660. A score above this number was a "prime" mortgage. A credit score below this number was labelled "subprime".

Initially taken up as a way to implement better IT systems, the fact that it was used by Freddie Mac, combined with its ease and scalability, meant that the FICO soon became the basis on which nearly all consumer credit in the US was assessed.

As Poon explains in painstaking detail, the adoption of the FICO score across the mortgage industry meant that it also became the test by which mortgage backed securities (like the now notorious "collateralised debt obligations", or "CDOs") were constructed.

CDOs were essentially bonds that paid a return based on the underlying mortgage interest of a series of home loans. Because each CDO was designed to have only a small proportion of risky loans, merchant banks were able to get ratings agencies like Moody’s to give them AAA ratings.

The process by which these ratings were calculated is explained in a fascinating New York Times article by Roger Lowenstein. He convinced Moody’s to let him have a look at an example of a mortgage-backed security, which Moody’s called "Subprime XYZ". This bond was rated as AAA — the top investment grade. Despite this, it actually contained 2393 mortgages, all of them subprime.

Lowenstein shows, from Moody’s own data, just how risky this bond really was:

"Three-quarters of the borrowers had adjustable-rate mortgages, or ARMs — ‘teaser’ loans on which the interest rate could be raised in short order. Since subprime borrowers cannot afford higher rates, they would need to refinance soon. This is a classic sign of a bubble — lending on the belief, or the hope, that new money will bail out the old. Moody’s learned that almost half of these borrowers — 43 per cent — did not provide written verification of their incomes."

Moody’s — like Fair Isaac and the mortgage industry in general — justified their ratings on statistical risk models based on previous default rates. This was a sound method of calculating the risk — as long as those historical trends continued. But risk is about future scenarios. And the conditions on the ground had changed.

"Credit scores," Lowenstein wrote, "long a mainstay of its analyses, had not proved to be a ‘strong predictor’ of defaults this time. Translation: even people with good credit scores were defaulting."

The reason was widespread fraud in the mortgage lending industry. This ranged from the usual "gaming" of the FICO score so customers could break through the magical 660 barrier, to outright loan-sharking and con-artistry.

A good example is Raymond Zwego, who was sentenced to 13 years jail in Kansas City last week for mortgage fraud. Zwego had used falsified documents to purchase 61 properties, obtaining US$16.9 million in fraudulent mortgages.

But for every Raymond Zwego, there were tens of thousands of ordinary Americans who convinced lenders they could buy the home of their dreams, despite lacking the income to pay for it.

Joe Bageant’s coruscating book Deer Hunting with Jesus, includes a chapter in which he investigates the practices of a leading mortgage agent in his home town in rural Virginia. Bageant reports that outright falsification of employment records to increase the FICO score — knowingly abetted by mortgage lenders — was rife.

The scale of the problem is shown by the fact that the FBI reportedly has 1400 investigations underway into organisations including Fannie Mae, Fredie Mac, AIG and Lehman Brothers.

The final piece of the puzzle was lax regulation. The reason that subprime crisis spread out into the broader financial markets was largely because of the size of the unregulated financial derivatives markets, of which mortgage backed securities were only a small proportion. The market for so-called credit-default swaps, for instance, is valued at $US62 trillion. No, that’s not a typo.

The sheer size of the derivatives markets is related to the enormous leverage required by institutions like merchant banks and hedge funds to gamble on various indices. Lehman Brothers is a good example. The bankrupt merchant bank had around $30 billion in cash and assets when it went to the wall. But it had liabilities on its books in excess of $600 billion. The size of that leverage meant that plunging investor confidence and a falling share price quickly proved terminal.

As I wrote back in March, the vast tides of unregulated derivatives washing around world money markets make periodic catastrophic failure in the financial markets almost certain: in sociologist Charles Perrow’s words, a "normal accident". In that article, I predicted that "stabilisation may require the US Treasury to step in and effectively take on trillions of dollars of bad debt".

That’s what we’re seeing this week. Who knows what next week will bring?