In my last post on Zero Hedge, we talked about why the shareholders of Fannie Mae and Freddie Mac don’t deserve any special consideration – except perhaps the sympathy of a priest or bartender. When you as a private investor are dumb enough to do business with a sovereign entity, don’t be surprised if you get screwed. See: “Don't Cry for the Shareholders of Fannie Mae and Freddie Mac”
This week, let’s talk about the release of the 2008 minutes from the Federal Open Market Committee and what they suggest for the future of the US economy. While it is pretty clear that the members of the FOMC eventually did the right thing five years ago in terms of reducing the cost of credit, the reasons behind the change in policy are less clear.
Five years ago, most of the Fed’s policy making body did not have a clue about the significance of what was happening in real markets and they still don’t. Just read the parts about Fed governors fretting about saving Lehman Brothers, a firm that could not be sold or saved. As Gretchen Morgenson wrote in the Sunday New York Times:
[T]hey paint a disturbing picture of a central bank that was in the dark about each looming disaster throughout 2008. That meant that the nation’s top bank regulators were unprepared to deal with the consequences of each new event.
Specifically, it seems that Fed Chair Janet Yellen et al did not then and still don’t really understand today why the markets fell apart in 2008-2009. Accordingly, they also don’t appreciate that raising rates without a concurrent increase in the demand for credit is a really bad idea. The whole push to lessen QE seems to be more about pleasing the talking heads in the financial media and boosting “confidence,” rather than effecting substantial change in the structure of the economy.
For a while now, we have been talking about how the negative effects of quantitative easing on savers are hurting the US economy. Robbing savers of $100 billion per quarter to subsidize the banks (and hundreds of billions more for subsidies to leveraged investors outside the banking system) is unfair and deflationary.
The vast flow of subsidies going to debtors also illustrates the extreme situation in which the US economy now stands, because even a modest increase in the cost of credit could also provoke a sharp downward spiral in stock and bond prices, albeit for different reasons. The crucial concern is that the level of demand in the US economy is still not sufficient to justify a significant rise in rates.
In fact, if the Fed raises the cost of credit too fast and before we see significant reforms in the US economy, the value of financial assets could start to fall. That is, too much taper could lead to deflation because we still have not fixed what is wrong with the financial markets. So while a modest adjustment in policy is good to give some relief to savers, the FOMC needs to help Congress understand what needs to happen in terms of structural market reform in order to restore credit demand. What reforms?
The Fed needs to lead the national discussion about what to do next. See my comment in The National Interest in that regard, “What Quantitative Easing Couldn't Do”
Now you are probably wondering, Chris, what is this about not enough reforms? Wasn’t Dodd-Frank enough reform from Washington? No, the trouble with Congress and the FOMC alike is that they don’t understand that the key reform needed in the US economy is not just to restrain acts of fraud and stupidity on Wall Street, which was a good idea, but to also end the monopoly on credit creation that exists between the TBTF banks and the US government. The chief obstacle to economic revival in the US is the monopoly over housing finance that exists between the top five commercial banks and the housing GSEs, including Fannie Mae, Freddie Mac and Ginnie Mae.
I am currently finishing a new book with my friend and mentor Fred Feldkamp, a retired partner of the Foley & Lardner law firm. The working title of the book is “Financial Stability: Fraud, Confidence & the Wealth of Nations.” The idea for the book and the concept of using credit spreads to judge the efficacy of public policy belongs to Fred, who is arguably the father of the “true sale” in the world of asset securitizations, at least in the period since the 1925 Supreme Court ruling written by Justice Louis Brandeis in Benedict v. Ratner. Below are some excerpts from our upcoming book.
When Fred got out of law school in the late 1960s, his first task was to find a way for private non-bank issuers of ABS to work a way around the draconian test for transparency and sale treatment in Benedict. If you don’t know of what I speak, read the first part of the paper I just completed for Indiana State University, “Dodd-Frank and the Great Debate: Regulation vs. Growth.”
Let’s start with a very short version of US financial history since WWII, something about which most market participants and FOMC members seem to know precious little. If you take the Benedict decision in 1925 as the starting point for the collapse of private finance in the U.S. economy, the ability of the private sector to create leverage outside of the broader government monopoly populated by large banks and corporations was limited until the early 1970s.
WWII, the Cold War and a lot of government spending got us out of the Great Depression and through three decades after the Second World War. By 1968, though, growth was slowing, inflation was rising and there was a battalion of paratroopers from the 82nd Airborne Division camped across the street from my parents’ house in the Cleveland Park section of Washington DC as cities from Chicago to Baltimore burned following the assassination of Martin Luther King.
In the 1970s, we saw the re-birth of private finance in the US with some of the earliest ABS deals based upon accounts receivable finance. Non-bank firms led the way, in part because of the continued regulation on the banks dating back to the Great Depression and partly because of non-financial firms were not required to consolidate their financing units.
Firms such as GM, Ford as well as many home builders could transfer ownership of assets to a 100% owned subsidiary in a “true sale” that was consistent with the Supreme Court’s decision in Benedict and raise money more easily than borrowing from a bank. Even though the interest paid on these bonds was taxed just like other securities, the advantage for non-bank firms was decisive and helped the US economy grow. As today, commercial banks were not willing or able to lend.
Because financial firms were required to consolidate debt issued by financial subsidiaries and homebuilders were not, that difference gave an advantage to the creative home builders that invented the structure. That advantage ended, however, in 1986 when the “Real Estate Mortgage Investment Conduits” or “REMIC” opened the housing finance market to financial firms.
Wall Street firms successfully lobbied Congress to do away with double taxation of mortgage bonds and adopted one model as the standard for "pass through" securities. The resulting legislation created the REMIC, which had much higher after-tax yields than other forms of mortgage-backed securities. By no coincidence, REMICs displaced other types of mortgage-backed securities and soon became the dominant choice of entity for such transactions issued by banks and federal housing agencies.
By the exclusivity REMIC required a few years later, the law closed out competition from non-financial firms for banks and broker dealers for issuing ABS such as collateralized mortgage obligations (“CMOs”). The REMIC, in effect, provides a monopoly position to financial firms in the world of housing finance and is really the underlying cause of the significant problems which have occurred since.
Borden and Reiss (2013) note that in the 2000s Wall Street firms often abused the Internal Revenue Service rules regarding the tax exemption of REITS, bringing into question whether the vehicles were properly constructed to qualify for tax exempt treatment. A 2012 suit filed by the New York Attorney General also details in its allegations how loan originators and REMIC sponsors on Wall Street colluded to populate REMICs with mortgages that did not comply with the REMIC rules.
Builders soon saw that financial firms were using REMIC CMOs to bid down spreads between newly originated mortgage securities and 10-year Treasury bonds to levels that made the deals less profitable than other opportunities. The business, therefore, became monopolized by a few large banks and housing GSEs in Washington, a monopoly that the SEC affirmed and compounded by also granting banks “monopsony” power over the CMO market in 1998.
The changes to the ABS market created via the bank/GSE monopoly granted by the REMIC soon destabilized the US economy. This market was severely disrupted by events in October 1987, then recovered near-equilibrium by 1990 and generally “flat-lined” until the enactment of Rule 3a-7 by the SEC. In 1992, the SEC adopted Rule 3a–7 under the Investment Company Act specifically to exclude from the definition of investment company certain asset-backed issuers.
The markets responded favorably to this change, but the revival of non-bank finance lasted just six short years. The forces of market monopolization led by the largest banks and GSEs started to “bubble up” in the late 1990s and won a total monopoly over the US mortgage markets following the amendments to the SEC’s Rule 2a-7 in 1998. In a very real sense, the SEC under Arthur Levitt set the stage for the subprime debacle a decade later. Even today, the SEC does not even understand the significance of their actions a decade ago.
It is important to understand the context behind two key rule changes made by the SEC in the 1990s, the adoption of Rule 3a-7 in 1992 and the amendments to Rule 2a-7 in 1998. The financial markets had struggled for balance from the 1987 crash throughout the presidency of George H. W. Bush despite resolving many issues. A group of lawyers that included Fred Feldkamp was asked to assess the reasons for the market dysfunction.
The group told then SEC Chairman Richard Breeden that the mortgage finance markets were balancing because of CMOs, but that this same stabilizing effect was not available for non-mortgage assets. The shorter maturity tranches of non-mortgage securitizations needed access to money market funds and the same legal exemptions that made mortgage deals work. CMOs for residential mortgages got the necessary legal exemption because they involved real estate -- an offshoot of the REIT exception to the Securities Act of 1940.
Eventually the SEC adopted Rule 3a-7 and new shelf-registration rules in December 1992, before Chairman Breeden left the SEC and after President Bill Clinton was elected. This change broke the logjam in the markets for non-mortgage securitizations and in the process helped make the Clinton Presidency one of the most successful in terms of economic growth in the past half century. The combination of vast cash inflows from payroll contributions by baby boomers to Social Security, which pushed down the federal deficit, and the changes to the rules for ABS, helped propel a remarkable period of private capital formation and growth in the US economy.
Within months of the adoption of Rule 3a-7, people were able to bring CMO technology to non-mortgage assets and short-term mortgage tranches to money market funds. The implementation of Rule 3a-7 by the SEC enabled the rescue of General Motors and its GMAC financing unit after the parent lost $23 billion in 1992 and was literally within weeks of filing Chapter 11. Market professionals created asset backed securities (“ABS”) and MBS-backed commercial paper using creativity and lots of bells and whistles. The change enabled non-bank firms to safely compete with banks for selling this paper to money market funds.
Abuses, however, allowed lots of scammers to exploit the rule changes made by the SEC. The creation of exceptions to the rule of prohibition carries with it both benefits and also dangers for the market and society. Dishonest market participants were able to create financial instruments that behaved like the type of safe, "current assets" required for backing commercial paper in money market funds -- but ONLY when interest rates were low. By creating financial instruments which contained massive amounts of hidden negative convexity, these market participants sponsored instruments that looked fine under a low rate environment, but "blew up" when the Fed caused a jump in mortgage rates early in 1994.
Among the casualties of that period was the firm Kidder Peabody, which was owned by General Electric at the time and following heavy losses was subsequently sold to PaineWebber in 1994. The SEC did not understand what happened. They tried to convict one of the worst offenders of the Kidder Peabody scandal, but the SEC’s lawyers never understood negative convexity sufficiently to explain to a jury that the guy was obviously a crook. The media portrayed the Kidder Peabody debacle as a case of insider trading, but the real cause of the collapse was the creation of toxic securities.
Rather than fix what was really wrong with Rule 3a-7, the SEC enacted amendments to Rule 2a-7 amendments in 1998. These changes gave a monopoly to banks when it came to issuing non-mortgage securitizations. Not only were all non-bank types of ABS-backed commercial paper effectively cut off by the SEC’s adoption of amendments to Rule 2a-7, the rules were written so any bank could get 5% of a money market for each structured investment vehicle they created to issue commercial paper.
A large bank, for example Citibank, could exploit this loophole and create 20 SIVs so that the bank could supply 100% of the assets owned by a money market fund. In order to compete with the advantage given to major banks, other firms found they needed to resort to scams (e.g., Lehman Brothers’ infamous "Repo-105" fraud) to get around the monopoly/monopsony created by the SEC’s 1998 amendments to Rule 2a-7. Both Bear, Stearns and Lehman committed corporate suicide trying to compete with the TBTF/GSE monopoly. But no private company can compete with a GSE.
As a result of the SEC’s 1998 amendments to Rule 2a-7, diversified, non-bank asset-backed securitizations that had neutralized the pricing power of bank conduits between 1992 and 1998 were cut off. In addition, despite rules intended to prevent credit concentrations at money market funds, the 1998 rules allowed a single sponsor to be the sole source of credit deficiency support behind 100 percent of all assets of all money market funds, merely by creating many conduits. It is, therefore, understandable that bank-controlled conduits came to dominate short-term commercial paper issuance in U.S. financial markets. Creation of this bank monopoly led to a series of market bubbles and crashes that the inherent stability of non-bank CMOs could not rectify.
Financial crises occurred with regularity after the SEC’s 1998 policy error. The SEC let a few large banks and the GSEs take near-total control of mortgage markets just as the mercantilist instincts of several major exporting nations began to flood the US with unprecedented (and, arguably, unneeded) liquidity. As risk spreads fell when foreign investors flooded US markets to support ages-old policies of mercantilists, “too big to fail” entities began to reduce the quality of underlying loans so they could buy them more cheaply and make front-ended profits. Most builders dared not do that because they were not “too big to fail” banks and would go broke buying back the loans in a slump.
By slipping “risk” in at the front end and using “off balance sheet” liabilities to pretend risk did not exist when selling CMOs, financial firms succeeded in driving this “magical” product into the ground, along with the world’s economy. As other investors learned how to “short” low-quality deals using derivatives, a “race to the bottom” began. That’s how modern history’s greatest financial invention – the non-bank CMO -- ended up nearly destroying the world in 2008.
As a consequence, CMOs issued after 1998 generally increase market volatility whenever an opportunity for abuse existed. CMOs are instruments designed to be held to maturity. That design characteristic cannot be sustained if a crisis necessitates the sale of CMOs by initial holders of the instruments. Therefore, when markets are de-stabilized by abuse, CMOs convert from “counter-cyclical” assets to “pro-cyclical” instruments that actually intensify market instability. Think of it this way: If the duration of a security jumps from 12 months to 12 years in a matter of weeks, the price of that bond is going to fall proportionately. In short, that instability converts COMs into financial weapons of mass destruction.
To fix the mess, Congress must end the bank/GSE monopoly that has dominated the US financial markets since 1998. We need to end the monopoly created by the adoption of the REMIC as the exclusive vehicle for MBS. Specifically, Congress needs end the exclusivity of the REMIC and reverse the changes made by the SEC in 1998 with respect to Rule 2a-7.
Congress ought to emphatically support efforts to reduce the instability that fraud creates whenever possible and also exercise its exclusive power to permit debt forgiveness with respect to bankruptcies. The 20-30 percent of Americans who today live in homes that are worth less than the mortgage face this dire situation because a decade ago the SEC handed the mortgage market to the TBTF banks and the GSEs. In both moral and economic terms, this situation needs to be fixed if the demand for credit in the US is to be revived. These steps are in the best interest of creditors, debtors, the US and the world, yet to date Congress has refused to do what must be done.
The Fed, for its part, needs to do some more work on the causes of the crisis and become an advocate for structural change in the US financial markets. QE was necessary to prevent the destruction of the equity in the global economy via a sudden asset price deflation, but that does not mean that the danger is past. Only by ending the structural monopoly enjoyed by the TBTF banks and GSEs in the mortgage market and more generally re-opening the financial markets to non-bank issuers of ABS can we begin to generate the levels of credit demand, job creation and growth that we all agree is a national priority.