Washington Post, September 28, 2008
By Elizabeth Razzi
We interrupt this financial crisis with a word from its sponsor: the families who are losing homes to foreclosure.
They're still circling the drain, to pick up on Federal Reserve Chairman Ben S. Bernanke's colorful metaphor describing credit markets as the economy's plumbing. Right now, the plumbing is clogged with bad securities backed by bad home mortgages. The federal bailout is designed to free up the system.
A separate bailout for troubled homeowners is supposed to launch this week. The new "Hope for Homeowners" program, passed in late July, is scheduled to go into effect Wednesday. (That's lightning speed by government standards.) It's designed to allow refinancing for people who cannot pay their mortgage and who can't refinance into something better because their home value is now too low to pay off the unaffordable old loan.
Under the program, those borrowers may qualify for a new, 30-year, fixed-rate mortgage insured by the Federal Housing Administration if (and it's a huge if) their current lender agrees to forgive enough of their debt so that they would have at least 10 percent equity, right now.
These FHA loans are not available to people who could afford to keep paying their current loans but who don't want to because the home has lost value. Nor are they available to investors, flippers or to anyone who owns a second home.
Lender participation is voluntary, and writing off principal is the last technique most will employ when trying to save borrowers from foreclosure. At a hearing before the House Financial Services Committee on Sept. 17, Molly Sheehan, senior vice president of Chase Home Lending, said, "The investor community still disfavors principal reduction."
In other words, the investors who own the bonds backed by these bad mortgages don't like to write off part of the debt owed so the homeowner can avoid foreclosure. They would rather try something else first, such as reducing the interest rate or stretching out the repayment period, which causes smaller losses to them. Or they might even prefer that the home goes into foreclosure.
Bank of America, which earlier this year bought big mortgage lender Countrywide, seems more accommodating than some other lenders. Michael Gross, managing director for loss mitigation, said BofA postponed all 1,650 foreclosures that were scheduled from Sept. 8 to Sep. 22 until at least Oct. 15 and is evaluating whether those borrowers might benefit from the new Hope refinance. "We will use this program where it is needed," he said. An estimated 30,000 to 40,000 of the bank's customers may qualify.
Relief will probably not arrive on the Wednesday start date. The final details of the program hadn't been published as of last week. And the folks on the front lines of the housing crisis -- housing and debt counselors -- certainly don't have the details.
Those counselors are overwhelmed right now. In Prince George's County, for example, it can take weeks to schedule an appointment with a counselor certified by the Housing and Urban Development Department. It's even tough to get a live person to answer the phone at many agencies.
Mary Dade, the housing counseling program manager for United Communities Against Poverty, a nonprofit community-action agency in Capitol Heights, said many of the people coming in for help simply have too much debt -- of all types -- to enable them to keep their homes. "We do have a problem with the economy right now," she said. "Just the amount of debt you see is overwhelming."
She has heard about the new Hope refinance program but isn't prepared to field questions from borrowers. "I don't think the housing-counseling agencies have been given a detailed briefing on that," she said. She added that she doesn't tend to get too excited about new programs because in the past they have helped relatively few borrowers.
Dade said she was trying to back away from focusing so much on foreclosures so that her program can still meet its other missions, such as providing pre-purchase counseling, assisting troubled renters and educating consumers about how to manage debt. "We can't spend 80 percent of our time on foreclosures," she said, noting that each foreclosure-prevention client requires about 20 hours of work.
She stressed that she's "not a mean person." It's just that many of the people who come through the door simply don't have the income to handle the debts, even with help. "This is my heart here," she said. "I want these people to come back into homeownership another time when they know what they are doing. . . . Homeownership is not for beginners."
Dade added that there's as big a problem with struggling renters in Prince George's County as with foreclosures. The number of evictions this year is on pace to match last year's 4,600, she said. Dade estimates that her organization is able to help about 56 percent of its cases. About 30 percent have other social issues or mental-health problems that they can't address. And the rest never follow up beyond the initial contact.
Sometimes the best help her office can provide is toward getting together the two or three months' worth of rent a person with bad credit needs for a security deposit on a rental.
William Johnson, executive director of Roots of Mankind, a nonprofit agency in Temple Hills, also said there are some owners they cannot help. "Most of them, we can," he said.
He said some lenders are already writing off some of the debt to make mortgages more affordable. But too many are still offering workouts that try to make up for missed payments by raising the amount owed each month. "If you can't pay $1,000, how are you going to pay $1,800? They're ridiculous," he said.
Johnson said it's all up to the lenders whether they offer "a decent workout." Chase and GMAC, he noted, have been excellent about creating workouts that actually work.
If you're in danger of losing your home, and you think you might qualify for one of the new Hope refinances -- or for other assistance, for that matter -- take the initiative. Call your loan servicer and ask about the Hope for Homeowners program. And, by all means, if your lender tries to reach you by mail, e-mail or phone, respond to the outreach. They may have good news about your eligibility for a refinanced loan you can afford.
28 September 2008
How the Rescue Affects Homeowners
Washington Post, Saturday, September 27, 2008
By Kenneth R. Harney
Whether you see it as an exorbitantly costly taxpayer bailout of Wall Street and the banks or you're cheering from the sidelines, you can agree: The new federal moves to rescue the mortgage system could have huge effects on consumers in the months ahead.
The chief architect of the plans, Treasury Secretary Henry M. Paulson Jr., says the costs could run into the "hundreds of billions" of dollars -- and that probably means higher taxes somewhere down the line.
On the other hand, Paulson argued persuasively to Congress that the costs to taxpayers of not acting, and allowing the global financial system to unravel day by day, would ultimately be much higher.
The jury will be out on that issue for years. But for consumers, especially those looking for a new mortgage or who are deep in trouble on their house payments, the plan could have more immediate, life-changing effects. Here's why:
A key part of the Treasury's plan requires no approval from Congress -- pumping billions of dollars of fresh capital into the home loan market through purchases of mortgage-backed securities. The Treasury already is committed to inject $10 billion this month, and it is expected to announce substantial purchases for an extended period.
Fannie Mae and Freddie Mac, now under conservatorship by the federal government, also have been directed to accelerate their investments in mortgage securities. The effect should be to supply additional dollars for home buyers and refinancers, and to keep a damper on interest rates. So far, so good: Rates for 30-year, fixed-rate loans have remained near 6 percent.
A second key impact of the rescue plan addresses the dire situations faced by the estimated 5 million homeowners who are behind on their mortgage payments, many of whom own houses that are worth less than the principal balances owed.
The new government-controlled entity that will buy portfolios of troubled mortgage assets from lenders and bond investors is likely to take a different approach to delinquent borrowers than does the private sector. Rather than the slow, loan-by-loan modification typical of banks -- what are known as "workouts" to lower rates, payments and even loan balances -- the new government entity is likely to adopt a fix-the-problem-in-bulk approach advocated by the Federal Deposit Insurance Corporation, the regulator and insurer of federally chartered banks.
The FDIC has decades of experience handling the acquired assets of failed banks, including, recently, the giant IndyMac Bank, which went under in July. IndyMac had 742,000 mortgages in its portfolio,
60,000 of which were 60 days delinquent or at some stage of foreclosure. One of the first actions the FDIC took after stepping in to pick up IndyMac's pieces was to declare an immediate halt to all foreclosure actions, pending a portfolio-wide review.
The idea, according to FDIC Chairman Sheila C. Bair, was to whistle a time out to "evaluate the problems and identify the best ways to maximize the value of the institution." Simply pushing through scheduled foreclosures on the bank's delinquent customers would not achieve that goal because foreclosures are extremely costly to lenders -- and catastrophic financially for borrowers.
A smarter strategy, Bair said, is to work out better terms for as many borrowers as possible, turning unaffordable, delinquent mortgages into affordable loans at current income levels. The best way to do that in a large portfolio is not on a retail, loan-by-loan basis, she argued, but rather by using a "systematic" approach where all delinquent borrowers who fit pre-set criteria could automatically qualify for a modification of terms.
After an initial review of the 60,000 late borrowers in the IndyMac portfolio, the FDIC deemed about 40,000 customers eligible for the loan-modification program. Modification terms include rate reductions, lengthening of payback timetables, rescheduling unpaid principal and interest, rate caps, and other techniques. In some cases, rates are reduced to 3 percent for five years, with increases of 1 percent a year until the note rate reaches a ceiling tied to current 30-year rates.
Unlike private-sector servicers, the FDIC charges no fees for its modifications. In the two months since taking over IndyMac, Bair said, more than 7,400 modification proposals have been sent to delinquent borrowers, and "thousands more" have received calls attempting to prevent "unnecessary foreclosures."
That sort of wholesale remedial strategy -- including a halt to potentially hundreds of thousands of foreclosures -- is what probably awaits financially distressed homeowners when the new federal rescue program kicks in and acquires their mortgages.
Call it what you want. But if you're one of those troubled borrowers, two words are likely to come to mind: home saver.
By Kenneth R. Harney
Whether you see it as an exorbitantly costly taxpayer bailout of Wall Street and the banks or you're cheering from the sidelines, you can agree: The new federal moves to rescue the mortgage system could have huge effects on consumers in the months ahead.
The chief architect of the plans, Treasury Secretary Henry M. Paulson Jr., says the costs could run into the "hundreds of billions" of dollars -- and that probably means higher taxes somewhere down the line.
On the other hand, Paulson argued persuasively to Congress that the costs to taxpayers of not acting, and allowing the global financial system to unravel day by day, would ultimately be much higher.
The jury will be out on that issue for years. But for consumers, especially those looking for a new mortgage or who are deep in trouble on their house payments, the plan could have more immediate, life-changing effects. Here's why:
A key part of the Treasury's plan requires no approval from Congress -- pumping billions of dollars of fresh capital into the home loan market through purchases of mortgage-backed securities. The Treasury already is committed to inject $10 billion this month, and it is expected to announce substantial purchases for an extended period.
Fannie Mae and Freddie Mac, now under conservatorship by the federal government, also have been directed to accelerate their investments in mortgage securities. The effect should be to supply additional dollars for home buyers and refinancers, and to keep a damper on interest rates. So far, so good: Rates for 30-year, fixed-rate loans have remained near 6 percent.
A second key impact of the rescue plan addresses the dire situations faced by the estimated 5 million homeowners who are behind on their mortgage payments, many of whom own houses that are worth less than the principal balances owed.
The new government-controlled entity that will buy portfolios of troubled mortgage assets from lenders and bond investors is likely to take a different approach to delinquent borrowers than does the private sector. Rather than the slow, loan-by-loan modification typical of banks -- what are known as "workouts" to lower rates, payments and even loan balances -- the new government entity is likely to adopt a fix-the-problem-in-bulk approach advocated by the Federal Deposit Insurance Corporation, the regulator and insurer of federally chartered banks.
The FDIC has decades of experience handling the acquired assets of failed banks, including, recently, the giant IndyMac Bank, which went under in July. IndyMac had 742,000 mortgages in its portfolio,
60,000 of which were 60 days delinquent or at some stage of foreclosure. One of the first actions the FDIC took after stepping in to pick up IndyMac's pieces was to declare an immediate halt to all foreclosure actions, pending a portfolio-wide review.
The idea, according to FDIC Chairman Sheila C. Bair, was to whistle a time out to "evaluate the problems and identify the best ways to maximize the value of the institution." Simply pushing through scheduled foreclosures on the bank's delinquent customers would not achieve that goal because foreclosures are extremely costly to lenders -- and catastrophic financially for borrowers.
A smarter strategy, Bair said, is to work out better terms for as many borrowers as possible, turning unaffordable, delinquent mortgages into affordable loans at current income levels. The best way to do that in a large portfolio is not on a retail, loan-by-loan basis, she argued, but rather by using a "systematic" approach where all delinquent borrowers who fit pre-set criteria could automatically qualify for a modification of terms.
After an initial review of the 60,000 late borrowers in the IndyMac portfolio, the FDIC deemed about 40,000 customers eligible for the loan-modification program. Modification terms include rate reductions, lengthening of payback timetables, rescheduling unpaid principal and interest, rate caps, and other techniques. In some cases, rates are reduced to 3 percent for five years, with increases of 1 percent a year until the note rate reaches a ceiling tied to current 30-year rates.
Unlike private-sector servicers, the FDIC charges no fees for its modifications. In the two months since taking over IndyMac, Bair said, more than 7,400 modification proposals have been sent to delinquent borrowers, and "thousands more" have received calls attempting to prevent "unnecessary foreclosures."
That sort of wholesale remedial strategy -- including a halt to potentially hundreds of thousands of foreclosures -- is what probably awaits financially distressed homeowners when the new federal rescue program kicks in and acquires their mortgages.
Call it what you want. But if you're one of those troubled borrowers, two words are likely to come to mind: home saver.
Behind Insurer’s Crisis, Blind Eye to a Web of Risk
New York Times, September 28, 2008
By GRETCHEN MORGENSON
“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”
— Joseph J. Cassano, a former A.I.G. executive, August 2007
Two weeks ago, the nation’s most powerful regulators and bankers huddled in the Lower Manhattan fortress that is the Federal Reserve Bank of New York, desperately trying to stave off disaster.
As the group, led by Treasury Secretary Henry M. Paulson Jr., pondered the collapse of one of America’s oldest investment banks, Lehman Brothers, a more dangerous threat emerged: American International Group, the world’s largest insurer, was teetering. A.I.G. needed billions of dollars to right itself and had suddenly begged for help.
The only Wall Street chief executive participating in the meeting was Lloyd C. Blankfein of Goldman Sachs, Mr. Paulson’s former firm. Mr. Blankfein had particular reason for concern.
Although it was not widely known, Goldman, a Wall Street stalwart that had seemed immune to its rivals’ woes, was A.I.G.’s largest trading partner, according to six people close to the insurer who requested anonymity because of confidentiality agreements. A collapse of the insurer threatened to leave a hole of as much as $20 billion in Goldman’s side, several of these people said.
Days later, federal officials, who had let Lehman die and initially balked at tossing a lifeline to A.I.G., ended up bailing out the insurer for $85 billion.
Their message was simple: Lehman was expendable. But if A.I.G. unspooled, so could some of the mightiest enterprises in the world.
A Goldman spokesman said in an interview that the firm was never imperiled by A.I.G.’s troubles and that Mr. Blankfein participated in the Fed discussions to safeguard the entire financial system, not his firm’s own interests.
Yet an exploration of A.I.G.’s demise and its relationships with firms like Goldman offers important insights into the mystifying, virally connected — and astonishingly fragile — financial world that began to implode in recent weeks.
Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them.
Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy.
In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world’s most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.
“It is beyond shocking that this small operation could blow up the holding company,” said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn. “They found a quick way to make a fast buck on derivatives based on A.I.G.’s solid credit rating and strong balance sheet. But it all got out of control.”
The London Office
The insurance giant’s London unit was known as A.I.G. Financial Products, or A.I.G.F.P. It was run with almost complete autonomy, and with an iron hand, by Joseph J. Cassano, according to current and former A.I.G. employees.
A onetime executive with Drexel Burnham Lambert — the investment bank made famous in the 1980s by the junk bond king Michael R. Milken, who later pleaded guilty to six felony charges — Mr. Cassano helped start the London unit in 1987.
The unit became profitable enough that analysts considered Mr. Cassano a dark horse candidate to succeed Maurice R. Greenberg, the longtime chief executive who shaped A.I.G. in his own image until he was ousted amid an accounting scandal three years ago.
But last February, Mr. Cassano resigned after the London unit began bleeding money and auditors raised questions about how the unit valued its holdings. By Sept. 15, the unit’s troubles forced a major downgrade in A.I.G.’s debt rating, requiring the company to post roughly $15 billion in additional collateral — which then prompted the federal rescue.
Mr. Cassano, 53, lives in a handsome, three-story town house in the Knightsbridge neighborhood of London, just around the corner from Harrods department store on a quiet square with a private garden.
He did not respond to interview requests left at his home and with his lawyer. An A.I.G. spokesman also declined to comment.
At A.I.G., Mr. Cassano found himself ensconced in a behemoth that had a long and storied history of deftly juggling risks. It insured people and properties against natural disasters and death, offered sophisticated asset management services and did so reliably and with bravado on many continents. Even now, its insurance subsidiaries are financially strong.
When Mr. Cassano first waded into the derivatives market, his biggest business was selling so-called plain vanilla products like interest rate swaps. Such swaps allow participants to bet on the direction of interest rates and, in theory, insulate themselves from unforeseen financial events.
Ten years ago, a “watershed” moment changed the profile of the derivatives that Mr. Cassano traded, according to a transcript of comments he made at an industry event last year. Derivatives specialists from J. P. Morgan, a leading bank that had many dealings with Mr. Cassano’s unit, came calling with a novel idea.
Morgan proposed the following: A.I.G. should try writing insurance on packages of debt known as “collateralized debt obligations.” C.D.O.’s. were pools of loans sliced into tranches and sold to investors based on the credit quality of the underlying securities.
The proposal meant that the London unit was essentially agreeing to provide insurance to financial institutions holding C.D.O.’s and other debts in case they defaulted — in much the same way some homeowners are required to buy mortgage insurance to protect lenders in case the borrowers cannot pay back their loans.
Under the terms of the insurance derivatives that the London unit underwrote, customers paid a premium to insure their debt for a period of time, usually four or five years, according to the company. Many European banks, for instance, paid A.I.G. to insure bonds that they held in their portfolios.
Because the underlying debt securities — mostly corporate issues and a smattering of mortgage securities — carried blue-chip ratings, A.I.G. Financial Products was happy to book income in exchange for providing insurance. After all, Mr. Cassano and his colleagues apparently assumed, they would never have to pay any claims.
Since A.I.G. itself was a highly rated company, it did not have to post collateral on the insurance it wrote, analysts said. That made the contracts all the more profitable.
These insurance products were known as “credit default swaps,” or C.D.S.’s in Wall Street argot, and the London unit used them to turn itself into a cash register.
The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999. Operating income at the unit also grew, rising to 17.5 percent of A.I.G.’s overall operating income in 2005, compared with 4.2 percent in 1999.
Profit margins on the business were enormous. In 2002, operating income was 44 percent of revenue; in 2005, it reached 83 percent.
Mr. Cassano and his colleagues minted tidy fortunes during these high-cotton years. Since 2001, compensation at the small unit ranged from $423 million to $616 million each year, according to corporate filings. That meant that on average each person in the unit made more than $1 million a year.
In fact, compensation expenses took a large percentage of the unit’s revenue. In lean years it was 33 percent; in fatter ones 46 percent. Over all, A.I.G. Financial Products paid its employees $3.56 billion during the last seven years.
The London unit’s reach was also vast. While clients and counterparties remain closely guarded secrets in the derivatives trade, Mr. Cassano talked publicly about how proud he was of his customer list.
At the 2007 conference he noted that his company worked with a “global swath” of top-notch entities that included “banks and investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals.”
Of course, as this intricate skein expanded over the years, it meant that the participants were linked to one another by contracts that existed for the most part inside the financial world’s version of a black box.
Goldman Sachs was a member of A.I.G.’s derivatives club, according to people familiar with the operation. It was a customer of A.I.G.’s credit insurance and also acted as an intermediary for trades between A.I.G. and its other clients.
Few knew of Goldman’s exposure to A.I.G. When the insurer’s flameout became public, David A. Viniar, Goldman’s chief financial officer, assured analysts on Sept. 16 that his firm’s exposure was “immaterial,” a view that the company reiterated in an interview.
Later that same day, the government announced its two-year, $85 billion loan to A.I.G., offering it a chance to sell its assets in an orderly fashion and theoretically repay taxpayers for their trouble. The plan saved the insurer’s trading partners but decimated its shareholders.
Lucas van Praag, a Goldman spokesman, declined to detail how badly hurt his firm might have been had A.I.G. collapsed two weeks ago. He disputed the calculation that Goldman had $20 billion worth of risk tied to A.I.G., saying the figure failed to account for collateral and hedges that Goldman deployed to reduce its risk.
Regarding Mr. Blankfein’s presence at the Fed during talks about an A.I.G. bailout, he said: “I think it would be a mistake to read into it that he was there because of our own interests. We were engaged because of the implications to the entire system.”
Mr. van Praag declined to comment on what communications, if any, took place between Mr. Blankfein and the Treasury secretary, Mr. Paulson, during the bailout discussions.
A Treasury spokeswoman declined to comment about the A.I.G. rescue and Goldman’s role. The government recently allowed Goldman to change its regulatory status to help bolster its finances amid the market turmoil.
An Executive’s Optimism
Regardless of Goldman’s exposure, by last year, A.I.G. Financial Products’ portfolio of credit default swaps stood at roughly $500 billion. It was generating as much as $250 million a year in income on insurance premiums, Mr. Cassano told investors.
Because it was not an insurance company, A.I.G. Financial Products did not have to report to state insurance regulators. But for the last four years, the London-based unit’s operations, whose trades were routed through Banque A.I.G., a French institution, were reviewed routinely by an American regulator, the Office of Thrift Supervision.
A handful of the agency’s officials were always on the scene at an A.I.G. Financial Products branch office in Connecticut, but it is unclear whether they raised any red flags. Their reports are not made public and a spokeswoman would not provide details.
For his part, Mr. Cassano apparently was not worried that his unit had taken on more than it could handle. In an August 2007 conference call with analysts, he described the credit default swaps as almost a sure thing.
“It is hard to get this message across, but these are very much handpicked,” he assured those on the phone.
Just a few months later, however, the credit crisis deepened. A.I.G. Financial Products began to choke on losses — though they were only on paper.
In the quarter that ended Sept. 30, 2007, A.I.G. recognized a $352 million unrealized loss on the credit default swap portfolio.
Because the London unit was set up as a bank and not an insurer, and because of the way its derivatives contracts were written, it had to put up collateral to its trading partners when the value of the underlying securities they had insured declined. Any obligations that the unit could not pay had to be met by its corporate parent.
So began A.I.G.’s downward spiral as it, its clients, its trading partners and other companies were swept into the drowning pool set in motion by the housing downturn.
Mortgage foreclosures set off questions about the quality of debts across the entire credit spectrum. When the value of other debts sagged, calls for collateral on the securities issued by the credit default swaps sideswiped A.I.G. Financial Products and its legendary, sprawling parent.
Yet throughout much of 2007, the unit maintained that its risk assessments were reliable and its portfolios conservative. Last fall, however, the methods that A.I.G. used to value its derivatives portfolio began to come under fire from trading partners.
In February, A.I.G.’s auditors identified problems in the firm’s swaps accounting. Then, three months ago, regulators and federal prosecutors said they were investigating the insurer’s accounting.
This was not the first time A.I.G. Financial Products had run afoul of authorities. In 2004, without admitting or denying accusations that it helped clients improperly burnish their financial statements, A.I.G. paid $126 million and entered into a deferred prosecution agreement to settle federal civil and criminal investigations.
The settlement was a black mark on A.I.G.’s reputation and, according to analysts, distressed Mr. Greenberg, who still ran the company at the time. Still, as Mr. Cassano later told investors, the case caused A.I.G. to improve its risk management and establish a committee to maintain quality control.
“That’s a committee that I sit on, along with many of the senior managers at A.I.G., and we look at a whole variety of transactions that come in to make sure that they are maintaining the quality that we need to,” Mr. Cassano told them. “And so I think the things that have been put in at our level and the things that have been put in at the parent level will ensure that there won’t be any of those kinds of mistakes again.”
At the end of A.I.G.’s most recent quarter, the London unit’s losses reached $25 billion.
As those losses mounted, and A.I.G.’s once formidable stock price plunged, it became harder for the insurer to survive — imperiling other companies that did business with it and leading it to stun the Federal Reserve gathering two weeks ago with a plea for help.
Mr. Greenberg, who has seen the value of his personal A.I.G. holdings decline by more than $5 billion this year, dumped five million shares late last week. A lawyer for Mr. Greenberg did not return a phone call seeking comment.
For his part, Mr. Cassano has departed from a company that is a far cry from what it was a year ago when he spoke confidently at the analyst conference.
“We’re sitting on a great balance sheet, a strong investment portfolio and a global trading platform where we can take advantage of the market in any variety of places,” he said then. “The question for us is, where in the capital markets can we gain the best opportunity, the best execution for the business acumen that sits in our shop?”
By GRETCHEN MORGENSON
“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”
— Joseph J. Cassano, a former A.I.G. executive, August 2007
Two weeks ago, the nation’s most powerful regulators and bankers huddled in the Lower Manhattan fortress that is the Federal Reserve Bank of New York, desperately trying to stave off disaster.
As the group, led by Treasury Secretary Henry M. Paulson Jr., pondered the collapse of one of America’s oldest investment banks, Lehman Brothers, a more dangerous threat emerged: American International Group, the world’s largest insurer, was teetering. A.I.G. needed billions of dollars to right itself and had suddenly begged for help.
The only Wall Street chief executive participating in the meeting was Lloyd C. Blankfein of Goldman Sachs, Mr. Paulson’s former firm. Mr. Blankfein had particular reason for concern.
Although it was not widely known, Goldman, a Wall Street stalwart that had seemed immune to its rivals’ woes, was A.I.G.’s largest trading partner, according to six people close to the insurer who requested anonymity because of confidentiality agreements. A collapse of the insurer threatened to leave a hole of as much as $20 billion in Goldman’s side, several of these people said.
Days later, federal officials, who had let Lehman die and initially balked at tossing a lifeline to A.I.G., ended up bailing out the insurer for $85 billion.
Their message was simple: Lehman was expendable. But if A.I.G. unspooled, so could some of the mightiest enterprises in the world.
A Goldman spokesman said in an interview that the firm was never imperiled by A.I.G.’s troubles and that Mr. Blankfein participated in the Fed discussions to safeguard the entire financial system, not his firm’s own interests.
Yet an exploration of A.I.G.’s demise and its relationships with firms like Goldman offers important insights into the mystifying, virally connected — and astonishingly fragile — financial world that began to implode in recent weeks.
Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them.
Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy.
In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world’s most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.
“It is beyond shocking that this small operation could blow up the holding company,” said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn. “They found a quick way to make a fast buck on derivatives based on A.I.G.’s solid credit rating and strong balance sheet. But it all got out of control.”
The London Office
The insurance giant’s London unit was known as A.I.G. Financial Products, or A.I.G.F.P. It was run with almost complete autonomy, and with an iron hand, by Joseph J. Cassano, according to current and former A.I.G. employees.
A onetime executive with Drexel Burnham Lambert — the investment bank made famous in the 1980s by the junk bond king Michael R. Milken, who later pleaded guilty to six felony charges — Mr. Cassano helped start the London unit in 1987.
The unit became profitable enough that analysts considered Mr. Cassano a dark horse candidate to succeed Maurice R. Greenberg, the longtime chief executive who shaped A.I.G. in his own image until he was ousted amid an accounting scandal three years ago.
But last February, Mr. Cassano resigned after the London unit began bleeding money and auditors raised questions about how the unit valued its holdings. By Sept. 15, the unit’s troubles forced a major downgrade in A.I.G.’s debt rating, requiring the company to post roughly $15 billion in additional collateral — which then prompted the federal rescue.
Mr. Cassano, 53, lives in a handsome, three-story town house in the Knightsbridge neighborhood of London, just around the corner from Harrods department store on a quiet square with a private garden.
He did not respond to interview requests left at his home and with his lawyer. An A.I.G. spokesman also declined to comment.
At A.I.G., Mr. Cassano found himself ensconced in a behemoth that had a long and storied history of deftly juggling risks. It insured people and properties against natural disasters and death, offered sophisticated asset management services and did so reliably and with bravado on many continents. Even now, its insurance subsidiaries are financially strong.
When Mr. Cassano first waded into the derivatives market, his biggest business was selling so-called plain vanilla products like interest rate swaps. Such swaps allow participants to bet on the direction of interest rates and, in theory, insulate themselves from unforeseen financial events.
Ten years ago, a “watershed” moment changed the profile of the derivatives that Mr. Cassano traded, according to a transcript of comments he made at an industry event last year. Derivatives specialists from J. P. Morgan, a leading bank that had many dealings with Mr. Cassano’s unit, came calling with a novel idea.
Morgan proposed the following: A.I.G. should try writing insurance on packages of debt known as “collateralized debt obligations.” C.D.O.’s. were pools of loans sliced into tranches and sold to investors based on the credit quality of the underlying securities.
The proposal meant that the London unit was essentially agreeing to provide insurance to financial institutions holding C.D.O.’s and other debts in case they defaulted — in much the same way some homeowners are required to buy mortgage insurance to protect lenders in case the borrowers cannot pay back their loans.
Under the terms of the insurance derivatives that the London unit underwrote, customers paid a premium to insure their debt for a period of time, usually four or five years, according to the company. Many European banks, for instance, paid A.I.G. to insure bonds that they held in their portfolios.
Because the underlying debt securities — mostly corporate issues and a smattering of mortgage securities — carried blue-chip ratings, A.I.G. Financial Products was happy to book income in exchange for providing insurance. After all, Mr. Cassano and his colleagues apparently assumed, they would never have to pay any claims.
Since A.I.G. itself was a highly rated company, it did not have to post collateral on the insurance it wrote, analysts said. That made the contracts all the more profitable.
These insurance products were known as “credit default swaps,” or C.D.S.’s in Wall Street argot, and the London unit used them to turn itself into a cash register.
The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999. Operating income at the unit also grew, rising to 17.5 percent of A.I.G.’s overall operating income in 2005, compared with 4.2 percent in 1999.
Profit margins on the business were enormous. In 2002, operating income was 44 percent of revenue; in 2005, it reached 83 percent.
Mr. Cassano and his colleagues minted tidy fortunes during these high-cotton years. Since 2001, compensation at the small unit ranged from $423 million to $616 million each year, according to corporate filings. That meant that on average each person in the unit made more than $1 million a year.
In fact, compensation expenses took a large percentage of the unit’s revenue. In lean years it was 33 percent; in fatter ones 46 percent. Over all, A.I.G. Financial Products paid its employees $3.56 billion during the last seven years.
The London unit’s reach was also vast. While clients and counterparties remain closely guarded secrets in the derivatives trade, Mr. Cassano talked publicly about how proud he was of his customer list.
At the 2007 conference he noted that his company worked with a “global swath” of top-notch entities that included “banks and investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals.”
Of course, as this intricate skein expanded over the years, it meant that the participants were linked to one another by contracts that existed for the most part inside the financial world’s version of a black box.
Goldman Sachs was a member of A.I.G.’s derivatives club, according to people familiar with the operation. It was a customer of A.I.G.’s credit insurance and also acted as an intermediary for trades between A.I.G. and its other clients.
Few knew of Goldman’s exposure to A.I.G. When the insurer’s flameout became public, David A. Viniar, Goldman’s chief financial officer, assured analysts on Sept. 16 that his firm’s exposure was “immaterial,” a view that the company reiterated in an interview.
Later that same day, the government announced its two-year, $85 billion loan to A.I.G., offering it a chance to sell its assets in an orderly fashion and theoretically repay taxpayers for their trouble. The plan saved the insurer’s trading partners but decimated its shareholders.
Lucas van Praag, a Goldman spokesman, declined to detail how badly hurt his firm might have been had A.I.G. collapsed two weeks ago. He disputed the calculation that Goldman had $20 billion worth of risk tied to A.I.G., saying the figure failed to account for collateral and hedges that Goldman deployed to reduce its risk.
Regarding Mr. Blankfein’s presence at the Fed during talks about an A.I.G. bailout, he said: “I think it would be a mistake to read into it that he was there because of our own interests. We were engaged because of the implications to the entire system.”
Mr. van Praag declined to comment on what communications, if any, took place between Mr. Blankfein and the Treasury secretary, Mr. Paulson, during the bailout discussions.
A Treasury spokeswoman declined to comment about the A.I.G. rescue and Goldman’s role. The government recently allowed Goldman to change its regulatory status to help bolster its finances amid the market turmoil.
An Executive’s Optimism
Regardless of Goldman’s exposure, by last year, A.I.G. Financial Products’ portfolio of credit default swaps stood at roughly $500 billion. It was generating as much as $250 million a year in income on insurance premiums, Mr. Cassano told investors.
Because it was not an insurance company, A.I.G. Financial Products did not have to report to state insurance regulators. But for the last four years, the London-based unit’s operations, whose trades were routed through Banque A.I.G., a French institution, were reviewed routinely by an American regulator, the Office of Thrift Supervision.
A handful of the agency’s officials were always on the scene at an A.I.G. Financial Products branch office in Connecticut, but it is unclear whether they raised any red flags. Their reports are not made public and a spokeswoman would not provide details.
For his part, Mr. Cassano apparently was not worried that his unit had taken on more than it could handle. In an August 2007 conference call with analysts, he described the credit default swaps as almost a sure thing.
“It is hard to get this message across, but these are very much handpicked,” he assured those on the phone.
Just a few months later, however, the credit crisis deepened. A.I.G. Financial Products began to choke on losses — though they were only on paper.
In the quarter that ended Sept. 30, 2007, A.I.G. recognized a $352 million unrealized loss on the credit default swap portfolio.
Because the London unit was set up as a bank and not an insurer, and because of the way its derivatives contracts were written, it had to put up collateral to its trading partners when the value of the underlying securities they had insured declined. Any obligations that the unit could not pay had to be met by its corporate parent.
So began A.I.G.’s downward spiral as it, its clients, its trading partners and other companies were swept into the drowning pool set in motion by the housing downturn.
Mortgage foreclosures set off questions about the quality of debts across the entire credit spectrum. When the value of other debts sagged, calls for collateral on the securities issued by the credit default swaps sideswiped A.I.G. Financial Products and its legendary, sprawling parent.
Yet throughout much of 2007, the unit maintained that its risk assessments were reliable and its portfolios conservative. Last fall, however, the methods that A.I.G. used to value its derivatives portfolio began to come under fire from trading partners.
In February, A.I.G.’s auditors identified problems in the firm’s swaps accounting. Then, three months ago, regulators and federal prosecutors said they were investigating the insurer’s accounting.
This was not the first time A.I.G. Financial Products had run afoul of authorities. In 2004, without admitting or denying accusations that it helped clients improperly burnish their financial statements, A.I.G. paid $126 million and entered into a deferred prosecution agreement to settle federal civil and criminal investigations.
The settlement was a black mark on A.I.G.’s reputation and, according to analysts, distressed Mr. Greenberg, who still ran the company at the time. Still, as Mr. Cassano later told investors, the case caused A.I.G. to improve its risk management and establish a committee to maintain quality control.
“That’s a committee that I sit on, along with many of the senior managers at A.I.G., and we look at a whole variety of transactions that come in to make sure that they are maintaining the quality that we need to,” Mr. Cassano told them. “And so I think the things that have been put in at our level and the things that have been put in at the parent level will ensure that there won’t be any of those kinds of mistakes again.”
At the end of A.I.G.’s most recent quarter, the London unit’s losses reached $25 billion.
As those losses mounted, and A.I.G.’s once formidable stock price plunged, it became harder for the insurer to survive — imperiling other companies that did business with it and leading it to stun the Federal Reserve gathering two weeks ago with a plea for help.
Mr. Greenberg, who has seen the value of his personal A.I.G. holdings decline by more than $5 billion this year, dumped five million shares late last week. A lawyer for Mr. Greenberg did not return a phone call seeking comment.
For his part, Mr. Cassano has departed from a company that is a far cry from what it was a year ago when he spoke confidently at the analyst conference.
“We’re sitting on a great balance sheet, a strong investment portfolio and a global trading platform where we can take advantage of the market in any variety of places,” he said then. “The question for us is, where in the capital markets can we gain the best opportunity, the best execution for the business acumen that sits in our shop?”
Everybody’s Business: In Financial Food Chains, Little Guys Can’t Win
New York Times, September 28, 2008
By BEN STEIN
Imagine, if you will, that a man who had much to do with creating the present credit crisis now says he is the man to fix this giant problem, and that his work is so important that he will need a trillion dollars or so of your money. Then add that this man thinks he is so indispensable that he wants Congress to forbid any judicial or administrative questioning of anything he does with your dollars.
You might think of a latter-day Lenin or Fidel Castro, but you would be far afield. Instead, you should be thinking of Treasury Secretary Henry M. Paulson Jr. and the rapidly disintegrating United States of America, right here and now.
But I am getting ahead of myself. First, I am furious at what the traders, speculators, hedge funds and the government have done to everyone who is saving and investing for retirement and future security. Millions of us did nothing wrong, according to the accepted wisdom of the age. We saved. We put a large part of our money into the stock market, as we were urged to do. Because the market wasn’t at ridiculously high levels, it seemed prudent to invest in broad indexes, foreign indexes and small- and large-cap indexes.
Now we have had the rug pulled out from under us. Our retirements have been put into severe jeopardy. The “earnings” part of those price-to-earnings ratios turns out to have been fiction for some financial companies, which normally account for a big part of total corporate earnings. In fact, earnings of giant finance players were often wildly negative, creating a situation rarely seen since the Great Depression, when the aggregate earnings of the Dow 30 were negative.
The current negativity occurred because of wild, casino-type operations of big finance players, creating liabilities way beyond anything we could have reasonably expected. This looks a lot like theft on a spectacular scale — of our wallets, our peace of mind, our futures.
Second, according to what I hear from my betters in the world of finance, the most serious problems are not with the bundles of subprime mortgages themselves — a large but not lethal quantum as far as I can tell — but with derivatives contracts tied to subprime and other dicey debt. These contracts are superficially an attempt to “insure” against risks of default, hence the name “credit-default swaps.” In fact, they are an immense wager — which anyone with lots of money or borrowing ability can enter — about how mortgage-backed bonds, leveraged loan bonds, student loan bonds, credit card bonds and the like will perform.
These wagers entail amounts many times larger than the total of subprime loans. In fact, there are roughly $62 trillion in credit-default swap derivatives out there, compared with about $1 trillion of subprime mortgages. These derivatives are “weapons of financial mass destruction,” in the prophetic words of Warren E. Buffett. (Apparently believing that the worst is over, at least for one big investment bank, Mr. Buffett is now investing in Goldman Sachs.)
The swaps market has been unregulated. It has been just a lot of people making bets with one another. Some of them made incredibly fortunate payoff wagers against the mortgage bonds, using credit-default swaps as their wagering vehicle. I am not sure who the big winners are, but they are out there, and the gains were big enough to cripple the part of Wall Street on the losing side of the bets.
Almost no one (except Mr. Buffett) saw this coming, at least not on this scale. But let’s get back to the man of the hour. Why didn’t Mr. Paulson, the Treasury secretary, see it? He was once the head of Goldman Sachs, an immense player in the swaps world. Didn’t people at Treasury have a clue? If they didn’t, what was going on in their heads? If they did, why didn’t they do something about it a year ago, when saving the world would have been a lot cheaper?
If Mr. Paulson and Ben S. Bernanke, the chairman of the Federal Reserve, didn’t see this train coming, what else have they missed? What other freight train is barreling down the track at us?
All of this would be bad enough. But by far the most terrifying item I read in my morning paper last week was this: Mr. Paulson demanded that Congress forbid judicial review of his decisions on use of the money in the mortgage bailout. This would amount to an abrogation of the Constitution. Not only would his decisions be sacrosanct and above the law, but so would the actions of his pals in the banking world in connection with this bailout.
The people whose conduct got us into this catastrophe have not only taken our money, hopes and peace of mind, but they apparently also want a trillion or so more dollars to put into their Wall Street Buddy System Fund. This may be the most dangerous attack on the law in my lifetime. What anarchists even dared consider this plan? Thank heaven that minds more devoted to the Constitution on Capitol Hill are questioning this shocking request.
By the way, if we are actually thinking about tossing the Constitution out the window, why not simply annul these credit-default swap contracts? With that done, the incomprehensibly large liability of the banks would cease, and we wouldn’t need this staggering bailout. Shouldn’t we consider making the speculators pay some of the price?
WE have survived housing-price corrections before. Why is this one causing so much anguish? It must be the side bets, the credit-default swap bets, multiplying the effect of the housing downturn many times over. Maybe we should just get rid of these exotic bets and start again without them. “Insurance” on market moves is always a bad idea, because it does not tamp down market disruptions but instead greatly magnifies them — as in the disastrous effect of “portfolio insurance” in the 1987 crash.
Then there was Mr. Paulson’s insistence that there be no compensation caps for executives of companies being bailed out by the factory workers, the farmers, the schoolteachers and the medical doctors. He told a skeptical Congress on Tuesday that if these caps were put into place, bank executives simply wouldn’t participate in the bailout or sell us suckers their debts. Fine with me. If the banks are in good enough shape so that petulant executives can simply opt out rather than live on a few million a year, maybe we don’t need the bailout at all. Maybe we would be better off if those executives simply bailed out and were replaced by people with more sense and more patriotism.
One final little thought bubbles into my mind: Maybe the bailout should not be of the banks at all, but of homeowners themselves. Maybe if we make the government the buyer of last resort of homes, we will stabilize the markets, stabilize the debt associated with the markets and take the gain out of the credit-default swaps for the speculators. Yes, price would be a huge issue, but so it is for Mr. Paulson’s plan for buying debt from banks.
Why not? We do it for farmers. Why not for the individual homeowner? Oh, right. Because Treasury secretaries don’t know any of those people.
Ben Stein is a lawyer, writer, actor and economist. E-mail: ebiz@nytimes.com.
By BEN STEIN
Imagine, if you will, that a man who had much to do with creating the present credit crisis now says he is the man to fix this giant problem, and that his work is so important that he will need a trillion dollars or so of your money. Then add that this man thinks he is so indispensable that he wants Congress to forbid any judicial or administrative questioning of anything he does with your dollars.
You might think of a latter-day Lenin or Fidel Castro, but you would be far afield. Instead, you should be thinking of Treasury Secretary Henry M. Paulson Jr. and the rapidly disintegrating United States of America, right here and now.
But I am getting ahead of myself. First, I am furious at what the traders, speculators, hedge funds and the government have done to everyone who is saving and investing for retirement and future security. Millions of us did nothing wrong, according to the accepted wisdom of the age. We saved. We put a large part of our money into the stock market, as we were urged to do. Because the market wasn’t at ridiculously high levels, it seemed prudent to invest in broad indexes, foreign indexes and small- and large-cap indexes.
Now we have had the rug pulled out from under us. Our retirements have been put into severe jeopardy. The “earnings” part of those price-to-earnings ratios turns out to have been fiction for some financial companies, which normally account for a big part of total corporate earnings. In fact, earnings of giant finance players were often wildly negative, creating a situation rarely seen since the Great Depression, when the aggregate earnings of the Dow 30 were negative.
The current negativity occurred because of wild, casino-type operations of big finance players, creating liabilities way beyond anything we could have reasonably expected. This looks a lot like theft on a spectacular scale — of our wallets, our peace of mind, our futures.
Second, according to what I hear from my betters in the world of finance, the most serious problems are not with the bundles of subprime mortgages themselves — a large but not lethal quantum as far as I can tell — but with derivatives contracts tied to subprime and other dicey debt. These contracts are superficially an attempt to “insure” against risks of default, hence the name “credit-default swaps.” In fact, they are an immense wager — which anyone with lots of money or borrowing ability can enter — about how mortgage-backed bonds, leveraged loan bonds, student loan bonds, credit card bonds and the like will perform.
These wagers entail amounts many times larger than the total of subprime loans. In fact, there are roughly $62 trillion in credit-default swap derivatives out there, compared with about $1 trillion of subprime mortgages. These derivatives are “weapons of financial mass destruction,” in the prophetic words of Warren E. Buffett. (Apparently believing that the worst is over, at least for one big investment bank, Mr. Buffett is now investing in Goldman Sachs.)
The swaps market has been unregulated. It has been just a lot of people making bets with one another. Some of them made incredibly fortunate payoff wagers against the mortgage bonds, using credit-default swaps as their wagering vehicle. I am not sure who the big winners are, but they are out there, and the gains were big enough to cripple the part of Wall Street on the losing side of the bets.
Almost no one (except Mr. Buffett) saw this coming, at least not on this scale. But let’s get back to the man of the hour. Why didn’t Mr. Paulson, the Treasury secretary, see it? He was once the head of Goldman Sachs, an immense player in the swaps world. Didn’t people at Treasury have a clue? If they didn’t, what was going on in their heads? If they did, why didn’t they do something about it a year ago, when saving the world would have been a lot cheaper?
If Mr. Paulson and Ben S. Bernanke, the chairman of the Federal Reserve, didn’t see this train coming, what else have they missed? What other freight train is barreling down the track at us?
All of this would be bad enough. But by far the most terrifying item I read in my morning paper last week was this: Mr. Paulson demanded that Congress forbid judicial review of his decisions on use of the money in the mortgage bailout. This would amount to an abrogation of the Constitution. Not only would his decisions be sacrosanct and above the law, but so would the actions of his pals in the banking world in connection with this bailout.
The people whose conduct got us into this catastrophe have not only taken our money, hopes and peace of mind, but they apparently also want a trillion or so more dollars to put into their Wall Street Buddy System Fund. This may be the most dangerous attack on the law in my lifetime. What anarchists even dared consider this plan? Thank heaven that minds more devoted to the Constitution on Capitol Hill are questioning this shocking request.
By the way, if we are actually thinking about tossing the Constitution out the window, why not simply annul these credit-default swap contracts? With that done, the incomprehensibly large liability of the banks would cease, and we wouldn’t need this staggering bailout. Shouldn’t we consider making the speculators pay some of the price?
WE have survived housing-price corrections before. Why is this one causing so much anguish? It must be the side bets, the credit-default swap bets, multiplying the effect of the housing downturn many times over. Maybe we should just get rid of these exotic bets and start again without them. “Insurance” on market moves is always a bad idea, because it does not tamp down market disruptions but instead greatly magnifies them — as in the disastrous effect of “portfolio insurance” in the 1987 crash.
Then there was Mr. Paulson’s insistence that there be no compensation caps for executives of companies being bailed out by the factory workers, the farmers, the schoolteachers and the medical doctors. He told a skeptical Congress on Tuesday that if these caps were put into place, bank executives simply wouldn’t participate in the bailout or sell us suckers their debts. Fine with me. If the banks are in good enough shape so that petulant executives can simply opt out rather than live on a few million a year, maybe we don’t need the bailout at all. Maybe we would be better off if those executives simply bailed out and were replaced by people with more sense and more patriotism.
One final little thought bubbles into my mind: Maybe the bailout should not be of the banks at all, but of homeowners themselves. Maybe if we make the government the buyer of last resort of homes, we will stabilize the markets, stabilize the debt associated with the markets and take the gain out of the credit-default swaps for the speculators. Yes, price would be a huge issue, but so it is for Mr. Paulson’s plan for buying debt from banks.
Why not? We do it for farmers. Why not for the individual homeowner? Oh, right. Because Treasury secretaries don’t know any of those people.
Ben Stein is a lawyer, writer, actor and economist. E-mail: ebiz@nytimes.com.
Fair Game: Your Money at Work, Fixing Others’ Mistakes
New York Times, September 21, 2008
By GRETCHEN MORGENSON
It looks as if we may get through this weekend without another scramble to save a troubled financial firm with a trillion-dollar balance sheet.
But that doesn’t mean taxpayers are out of danger. No, sir. No, ma’am. Because lawmakers are at work on a bailout fund that would buy the kind of distressed assets (defaulted mortgages, for example) that have ignited this firestorm.
Treasury Secretary Henry M. Paulson Jr. has called the fund the “troubled asset relief program.” I’ll just call it TARP for short (you know, the kind of thing they spread over muddy fields so you don’t soil your Guccis).
And depending on how TARP is operated, and how the assets are valued before taxpayers are forced to buy them, it could bloat our final bill for this mess while benefiting the very institutions that got us into it.
Yes, we need a smart plan and a concerted effort to get the frozen credit markets up and running. But we also have to be certain that the types of conflicts of interest that riddle Wall Street aren’t visited upon TARP.
Consider: A bank wants to sell the TARPistas (also known as TAXPAYERS) a pile of stinky mortgage securities that it currently values at 60 cents on the dollar. Let’s assume that the most recent actual trade between market participants for similar assets was struck at 30 cents on the dollar.
So what’s a fair price that we TARPistas should pay for the assets?
If we bought at 60 cents, a price that the bank would argue is appropriate, we would most likely face a loss. The bank, however, would be much better off than if it had to dump at 30 cents.
Conversely, if the assets were sold at 30 cents, taxpayers could wind up making a profit on the purchase if the assets performed better than expected over time. But the bank would have to write down the value of the assets as a result of the sale, possibly threatening its financial standing yet again.
Do you think, perchance, that financial services lobbyists might be working their Hill contacts right this very minute to ensure that the TARP valuations are rigged in their favor?
You know the answer to that.
And you also know that we should steel ourselves for heavy losses as the TARP gets pulled over our eyes. Never mind that it was the banks, with their reckless lending and monumental leverage, that drove us into this ditch.
Such is our lot today: They break it. We own it.
Taxpayers deserve better than this, of course. But we have no lobbyists, so we get skinned.
IF federal regulators and political leaders want to earn back some trust, they could do two things. First, they could provide us with some transparency about whom precisely we are backing in the recent bailouts.
Take, for example, the rescue on Tuesday of the American International Group, once the world’s largest insurance company. It was pretty breathtaking. Since when do insurance companies, whose business models seem to consist of taking in premiums and stonewalling claims, deserve rescues from beleaguered taxpayers?
Answer: Ever since the world became so intertwined that the failure of one company can topple a host of others. And ever since credit default swaps, those unregulated derivative contracts that allow investors to bet on a debt issuer’s financial prospects, loomed so big on balance sheets that they now drive every bailout decision.
The deal to save A.I.G. involves a two-year, $85 billion loan from taxpayers. In exchange, the new owners — us — get 80 percent of the company. If enough of A.I.G.’s assets are sold for good prices, we may get our money back.
Credit default swaps, which operate like insurance policies against the possibility that an issuer of debt will not pay on its obligations, were the single biggest motivator behind the A.I.G. deal.
A.I.G. had written $441 billion in credit insurance on mortgage-related securities whose values have declined; if A.I.G. were to fail, all the institutions that bought the insurance would have been subject to enormous losses. The ripple effect could have turned into a tsunami.
So, the $85 billion loan to A.I.G. was really a bailout of the company’s counterparties or trading partners.
Now, inquiring minds want to know, whom did we rescue? Which large, wealthy financial institutions — counterparties to A.I.G.’s derivatives contracts — benefited from the taxpayers’ $85 billion loan? Were their representatives involved in the talks that resulted in the last-minute loan?
And did Lehman Brothers not get bailed out because those favored institutions were not on the hook if it failed?
We’ll probably never know the answers to these troubling questions. But by keeping taxpayers in the dark, regulators continue to earn our mistrust. As long as we are not told whom we have bailed out, we will be justified in suspecting that a favored few are making gains on our dimes.
A.I.G.’s financial statements provided a clue to the identities of some of its credit default swap counterparties. The company said that almost three-quarters of the $441 billion it had written on soured mortgage securities was bought by European banks. The banks bought the insurance to reduce the amounts of capital they were required by regulators to set aside to cover future losses.
Enjoy the absurdity: Billions in unregulated derivatives that were about to take down the insurance company that sold them were bought by banks to get around their regulatory capital requirements intended to rein in risk.
Got that?
Which brings us to Item 2 for policy makers. Stop pretending that the $62 trillion market for credit default swaps does not need regulatory oversight. Warren E. Buffett was not engaging in hyperbole when he called these things financial weapons of mass destruction.
“The last eight years have been about permitting derivatives to explode, knowing they were unregulated,” said Eric R. Dinallo, New York’s superintendent of insurance. “It’s about what the government chose not to regulate, measured in dollars. And that is what shook the world.”
And it will continue.
By GRETCHEN MORGENSON
It looks as if we may get through this weekend without another scramble to save a troubled financial firm with a trillion-dollar balance sheet.
But that doesn’t mean taxpayers are out of danger. No, sir. No, ma’am. Because lawmakers are at work on a bailout fund that would buy the kind of distressed assets (defaulted mortgages, for example) that have ignited this firestorm.
Treasury Secretary Henry M. Paulson Jr. has called the fund the “troubled asset relief program.” I’ll just call it TARP for short (you know, the kind of thing they spread over muddy fields so you don’t soil your Guccis).
And depending on how TARP is operated, and how the assets are valued before taxpayers are forced to buy them, it could bloat our final bill for this mess while benefiting the very institutions that got us into it.
Yes, we need a smart plan and a concerted effort to get the frozen credit markets up and running. But we also have to be certain that the types of conflicts of interest that riddle Wall Street aren’t visited upon TARP.
Consider: A bank wants to sell the TARPistas (also known as TAXPAYERS) a pile of stinky mortgage securities that it currently values at 60 cents on the dollar. Let’s assume that the most recent actual trade between market participants for similar assets was struck at 30 cents on the dollar.
So what’s a fair price that we TARPistas should pay for the assets?
If we bought at 60 cents, a price that the bank would argue is appropriate, we would most likely face a loss. The bank, however, would be much better off than if it had to dump at 30 cents.
Conversely, if the assets were sold at 30 cents, taxpayers could wind up making a profit on the purchase if the assets performed better than expected over time. But the bank would have to write down the value of the assets as a result of the sale, possibly threatening its financial standing yet again.
Do you think, perchance, that financial services lobbyists might be working their Hill contacts right this very minute to ensure that the TARP valuations are rigged in their favor?
You know the answer to that.
And you also know that we should steel ourselves for heavy losses as the TARP gets pulled over our eyes. Never mind that it was the banks, with their reckless lending and monumental leverage, that drove us into this ditch.
Such is our lot today: They break it. We own it.
Taxpayers deserve better than this, of course. But we have no lobbyists, so we get skinned.
IF federal regulators and political leaders want to earn back some trust, they could do two things. First, they could provide us with some transparency about whom precisely we are backing in the recent bailouts.
Take, for example, the rescue on Tuesday of the American International Group, once the world’s largest insurance company. It was pretty breathtaking. Since when do insurance companies, whose business models seem to consist of taking in premiums and stonewalling claims, deserve rescues from beleaguered taxpayers?
Answer: Ever since the world became so intertwined that the failure of one company can topple a host of others. And ever since credit default swaps, those unregulated derivative contracts that allow investors to bet on a debt issuer’s financial prospects, loomed so big on balance sheets that they now drive every bailout decision.
The deal to save A.I.G. involves a two-year, $85 billion loan from taxpayers. In exchange, the new owners — us — get 80 percent of the company. If enough of A.I.G.’s assets are sold for good prices, we may get our money back.
Credit default swaps, which operate like insurance policies against the possibility that an issuer of debt will not pay on its obligations, were the single biggest motivator behind the A.I.G. deal.
A.I.G. had written $441 billion in credit insurance on mortgage-related securities whose values have declined; if A.I.G. were to fail, all the institutions that bought the insurance would have been subject to enormous losses. The ripple effect could have turned into a tsunami.
So, the $85 billion loan to A.I.G. was really a bailout of the company’s counterparties or trading partners.
Now, inquiring minds want to know, whom did we rescue? Which large, wealthy financial institutions — counterparties to A.I.G.’s derivatives contracts — benefited from the taxpayers’ $85 billion loan? Were their representatives involved in the talks that resulted in the last-minute loan?
And did Lehman Brothers not get bailed out because those favored institutions were not on the hook if it failed?
We’ll probably never know the answers to these troubling questions. But by keeping taxpayers in the dark, regulators continue to earn our mistrust. As long as we are not told whom we have bailed out, we will be justified in suspecting that a favored few are making gains on our dimes.
A.I.G.’s financial statements provided a clue to the identities of some of its credit default swap counterparties. The company said that almost three-quarters of the $441 billion it had written on soured mortgage securities was bought by European banks. The banks bought the insurance to reduce the amounts of capital they were required by regulators to set aside to cover future losses.
Enjoy the absurdity: Billions in unregulated derivatives that were about to take down the insurance company that sold them were bought by banks to get around their regulatory capital requirements intended to rein in risk.
Got that?
Which brings us to Item 2 for policy makers. Stop pretending that the $62 trillion market for credit default swaps does not need regulatory oversight. Warren E. Buffett was not engaging in hyperbole when he called these things financial weapons of mass destruction.
“The last eight years have been about permitting derivatives to explode, knowing they were unregulated,” said Eric R. Dinallo, New York’s superintendent of insurance. “It’s about what the government chose not to regulate, measured in dollars. And that is what shook the world.”
And it will continue.
Worst Crisis Since '30s, With No End Yet in Sight
Wall Street Journal, September 18, 2008
By JON HILSENRATH, SERENA NG and DAMIAN PALETTA
The financial crisis that began 13 months ago has entered a new, far more serious phase.
Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem -- troubled subprime mortgages -- in areas like credit-default swaps, the credit insurance contracts sold by American International Group Inc. and others. There's also a growing sense of wariness about the health of trading partners.
The consequences for companies and chief executives who tarry -- hoping for better times in which to raise capital, sell assets or acknowledge losses -- are now clear and brutal, as falling share prices and fearful lenders send troubled companies into ever-deeper holes. This weekend, such a realization led John Thain to sell the century-old Merrill Lynch & Co. to Bank of America Corp. Each episode seems to bring government intervention that is more extensive and expensive than the previous one, and carries greater risk of unintended consequences.
Expectations for a quick end to the crisis are fading fast. "I think it's going to last a lot longer than perhaps we would have anticipated," Anne Mulcahy, chief executive of Xerox Corp., said Wednesday.
"This has been the worst financial crisis since the Great Depression. There is no question about it," said Mark Gertler, a New York University economist who worked with fellow academic Ben Bernanke, now the Federal Reserve chairman, to explain how financial turmoil can infect the overall economy. "But at the same time we have the policy mechanisms in place fighting it, which is something we didn't have during the Great Depression."
Spreading Disease
The U.S. financial system resembles a patient in intensive care. The body is trying to fight off a disease that is spreading, and as it does so, the body convulses, settles for a time and then convulses again. The illness seems to be overwhelming the self-healing tendencies of markets. The doctors in charge are resorting to ever-more invasive treatment, and are now experimenting with remedies that have never before been applied. Fed Chairman Bernanke and Treasury Secretary Henry Paulson, walking into a hastily arranged meeting with congressional leaders Tuesday night to brief them on the government's unprecedented rescue of AIG, looked like exhausted surgeons delivering grim news to the family.
In the wake of this past week's market meltdown, WSJ's economics editor David Wessel looks at the shakeup and sees one of two outcomes: the crisis as catharsis or a drawn-out mess.
Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt. During the credit boom, financial institutions and American households took on too much debt. Between 2002 and 2006, household borrowing grew at an average annual rate of 11%, far outpacing overall economic growth. Borrowing by financial institutions grew by a 10% annualized rate. Now many of those borrowers can't pay back the loans, a problem that is exacerbated by the collapse in housing prices. They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.
At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets.
But many of the distressed assets are hard to value and there are few if any buyers. Deleveraging also feeds on itself in a way that can create a downward spiral: Trying to sell assets pushes down the assets' prices, which makes them harder to sell and leads firms to try to sell more assets. That, in turn, suppresses these firms' share prices and makes it harder for them to sell new shares to raise capital. Mr. Bernanke, as an academic, dubbed this self-feeding loop a "financial accelerator."
[annualized yield on the 3 month Treasury bill]
"Many of the CEO types weren't willing...to take these losses, and say, 'I accept the fact that I'm selling these way below fundamental value,'" said Anil Kashyap, a University of Chicago Business School economics professor. "The ones that had the biggest exposure, they've all died."
Deleveraging started with securities tied to subprime mortgages, where defaults started rising rapidly in 2006. But the deleveraging process has now spread well beyond, to commercial real estate and auto loans to the short-term commitments on which investment banks rely to fund themselves. In the first quarter, financial-sector borrowing slowed to a 5.1% growth rate, about half of the average from 2002 to 2007. Household borrowing has slowed even more, to a 3.5% pace.
Goldman Sachs Group Inc. economist Jan Hatzius estimates that in the past year, financial institutions around the world have already written down $408 billion worth of assets and raised $367 billion worth of capital.
But that doesn't appear to be enough. Every time financial firms and investors suggest that they've written assets down enough and raised enough new capital, a new wave of selling triggers a reevaluation, propelling the crisis into new territory. Residential mortgage losses alone could hit $636 billion by 2012, Goldman estimates, triggering widespread retrenchment in bank lending. That could shave 1.8 percentage points a year off economic growth in 2008 and 2009 -- the equivalent of $250 billion in lost goods and services each year.
"This is a deleveraging like nothing we've ever seen before," said Robert Glauber, now a professor of Harvard's government and law schools who came to Washington in 1989 to help organize the savings and loan cleanup of the early 1990s. "The S&L losses to the government were small compared to this."
Hedge funds could be among the next problem areas. Many rely on borrowed money to amplify their returns. With banks under pressure, many hedge funds are less able to borrow this money now, pressuring returns. Meanwhile, there are growing indications that fewer investors are shifting into hedge funds while others are pulling out. Fund investors are dealing with their own problems: Many have taken out loans to make their investments and are finding it more difficult now to borrow.
That all makes it likely that more hedge funds will shutter in the months ahead, forcing them to sell their investments, further weighing on the market.
Debt-driven financial traumas have a long history, from the Great Depression to the S&L crisis to the Asian financial crisis of the late 1990s. Neither economists nor policymakers have easy solutions. Cutting interest rates and writing stimulus checks to families can help -- and may have prevented or delayed a deep recession. But, at least in this instance, they don't suffice.
In such circumstances, governments almost invariably experiment with solutions with varying degrees of success. President Franklin Delano Roosevelt unleashed an alphabet soup of new agencies and a host of new regulations in the aftermath of the market crash of 1929. In the 1990s, Japan embarked on a decade of often-wasteful government spending to counter the aftereffects of a bursting bubble. President George H.W. Bush and Congress created the Resolution Trust Corp. to take and sell the assets of failed thrifts. Hong Kong's free-market government went on a massive stock-buying spree in 1998, buying up shares of every company listed in the benchmark Hang Seng index. It ended up packaging them into an exchange-traded fund and making money.
Today, Mr. Bernanke is taking out his playbook, said NYU economist Mr. Gertler, "and rewriting it as we go."
Merrill Lynch & Co.'s emergency sale to Bank of America Corp. last weekend was an example of the perniciousness and unpredictability of deleveraging. In the past year, Merrill had hired a new chief executive, written off $41.4 billion in assets and raised $21 billion in equity capital.
But Merrill couldn't keep up. The more it raised, the more it was forced to write off. When Merrill CEO John Thain attended a meeting with the New York Fed and other Wall Street executives last week, he saw that Merrill was the next most vulnerable brokerage firm. "We watched Bear and Lehman. We knew we could be next," said one Merrill executive. Fearful that its lenders would shut the firm off, he sold to Bank of America.
Traders on the floor of the New York Stock Exchange Wednesday. Expectations for a quick end to the crisis are fading fast.
This crisis is complicated by innovative financial instruments that Wall Street created and distributed. They're making it harder for officials and Wall Street executives to know where the next set of risks is hiding and also contributing to the crisis's spreading impact.
Swaps Game
The latest trouble spot is an area called credit-default swaps, which are private contracts that let firms trade bets on whether a borrower is going to default. When a default occurs, one party pays off the other. The value of the swaps rise and fall as the market reassesses the risk that a company won't be able to honor its obligations. Firms use these instruments both as insurance -- to hedge their exposures to risk -- and to wager on the health of other companies. There are now credit-default swaps on more than $62 trillion in debt, up from about $144 billion a decade ago.
One of the big new players in the swaps game was AIG, the world's largest insurer and a major seller of credit-default swaps to financial institutions and companies. When the credit markets were booming, many firms bought these instruments from AIG, believing the insurance giant's strong credit ratings and large balance sheet could provide a shield against bond and loan defaults. AIG believed the risk of default was low on many securities it insured.
As of June 30, an AIG unit had written credit-default swaps on more than $446 billion in credit assets, including mortgage securities, corporate loans and complex structured products. Last year, when rising subprime-mortgage delinquencies damaged the value of many securities AIG had insured, the firm was forced to book large write-downs on its derivative positions. That spooked investors, who reacted by dumping its shares, making it harder for AIG to raise the capital it increasingly needed.
Credit default swaps "didn't cause the problem, but they certainly exacerbated the financial crisis," said Leslie Rahl, president of Capital Market Risk Advisors, a consulting firm in New York. The sheer volume of CDS contracts outstanding -- and the fact that they trade directly between institutions, without centralized clearing -- intertwined the fates of many large banks and brokerages.
Few financial crises have been sorted out in modern times without massive government intervention. Increasingly, officials are coming to the conclusion that even more might be needed. A big problem: The Fed can and has provided short-term money to sound, but struggling, institutions that are out of favor. It can, and has, reduced the interest rates it influences to attempt to reduce borrowing costs through the economy and encourage investment and spending.
But it is ill-equipped to provide the capital that financial institutions now desperately need to shore up their finances and expand lending.
Resolution Trust Scenario
In normal times, capital-starved companies usually can raise money on their own. In the current crisis, a number of big Wall Street firms, including Citigroup Inc., have turned to sovereign-wealth funds, the government-controlled pools of money.
But both on Wall Street and in Washington, there is increasing expectation that U.S. taxpayers will either take the bad assets off the hands of financial institutions so they can raise capital, or put taxpayer capital into the companies, as the Treasury has agreed to do with mortgage giants Fannie Mae and Freddie Mac.
One proposal was raised by Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee. Rep. Frank is looking at whether to create an analog to the Resolution Trust Corp., which took assets from failed banks and thrifts and found buyers over several years.
"When you have a big loss in the marketplace, there are only three people that can take the loss -- the bondholders, the shareholders and the government," said William Seidman, who led the RTC from 1989 to 1991. "That's the dance we're seeing right now. Are we going to shove this loss into the hands of the taxpayers?"
The RTC seemed controversial and ambitious at the time. Any version today would be even more complex. The RTC dispensed mostly of commercial real estate. Today's troubled assets are complex debt securities -- many of which include pieces of other instruments, which in turn include pieces of others, many steps removed from the actual mortgages or consumer loans on which they are based. Unraveling these strands will be tedious and getting at the underlying collateral, difficult.
In the early stages of this crisis, regulators saw that their rules didn't fit the rapidly changing financial system they were asked to oversee. Investment banks, at the core of the crisis, weren't as closely monitored by the Securities and Exchange Commission as commercial banks were by their regulators.
The government has a system to close failed banks, created after the Great Depression in part to avoid sudden runs by depositors. Now, runs happen in spheres regulators may not fully understand, such as the repurchase agreement, or repo, market, in which investment banks fund their day-to-day operations. And regulators have no process for handling the failure of an investment bank like Lehman Brothers Holdings Inc. Insurers like AIG aren't even federally regulated.
Regulators have all but promised that more banks will fail in the coming months. The Federal Deposit Insurance Corp. is drawing up a plan to raise the premiums it charges banks so that it can rebuild the fund it uses to back deposits. Examiners are tightening their leash on banks across the country.
Pleasant Mystery
One pleasant mystery is why the crisis hasn't hit the economy harder -- at least so far. "This financial crisis hasn't yet translated into fewer...companies starting up, less research and development, less marketing," Ivan Seidenberg, chief executive of Verizon Communications, said Wednesday. "We haven't seen that yet. I'm sure every company is keeping their eyes on it."
At 6.1%, the unemployment rate remains well below the peak of 7.8% in 1992, amid the S&L crisis.
In part, that's because government has reacted aggressively. The Fed's classic mistake that led to the Great Depression was that it tightened monetary policy when it should have eased. Mr. Bernanke didn't repeat that error. And Congress moved more swiftly to approve fiscal stimulus than most Washington veterans thought possible.
In part, the broader economy has held mostly steady because exports have been so strong at just the right moment, a reminder of the global economy's importance to the U.S. And in part, it's because the U.S. economy is demonstrating impressive resilience, as information technology allows executives to react more quickly to emerging problems and -- to the discomfort of workers -- companies are quicker to adjust wages, hiring and work hours when the economy softens.
But the risk remains that Wall Street's woes will spread to Main Street, as credit tightens for consumers and business. Already, U.S. auto makers have been forced to tighten the terms on their leasing programs, or abandon writing leases themselves altogether, because of problems in their finance units. Goldman Sachs economists' optimistic scenario is a couple years of mild recession or painfully slow economy growth.
By JON HILSENRATH, SERENA NG and DAMIAN PALETTA
The financial crisis that began 13 months ago has entered a new, far more serious phase.
Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem -- troubled subprime mortgages -- in areas like credit-default swaps, the credit insurance contracts sold by American International Group Inc. and others. There's also a growing sense of wariness about the health of trading partners.
The consequences for companies and chief executives who tarry -- hoping for better times in which to raise capital, sell assets or acknowledge losses -- are now clear and brutal, as falling share prices and fearful lenders send troubled companies into ever-deeper holes. This weekend, such a realization led John Thain to sell the century-old Merrill Lynch & Co. to Bank of America Corp. Each episode seems to bring government intervention that is more extensive and expensive than the previous one, and carries greater risk of unintended consequences.
Expectations for a quick end to the crisis are fading fast. "I think it's going to last a lot longer than perhaps we would have anticipated," Anne Mulcahy, chief executive of Xerox Corp., said Wednesday.
"This has been the worst financial crisis since the Great Depression. There is no question about it," said Mark Gertler, a New York University economist who worked with fellow academic Ben Bernanke, now the Federal Reserve chairman, to explain how financial turmoil can infect the overall economy. "But at the same time we have the policy mechanisms in place fighting it, which is something we didn't have during the Great Depression."
Spreading Disease
The U.S. financial system resembles a patient in intensive care. The body is trying to fight off a disease that is spreading, and as it does so, the body convulses, settles for a time and then convulses again. The illness seems to be overwhelming the self-healing tendencies of markets. The doctors in charge are resorting to ever-more invasive treatment, and are now experimenting with remedies that have never before been applied. Fed Chairman Bernanke and Treasury Secretary Henry Paulson, walking into a hastily arranged meeting with congressional leaders Tuesday night to brief them on the government's unprecedented rescue of AIG, looked like exhausted surgeons delivering grim news to the family.
In the wake of this past week's market meltdown, WSJ's economics editor David Wessel looks at the shakeup and sees one of two outcomes: the crisis as catharsis or a drawn-out mess.
Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt. During the credit boom, financial institutions and American households took on too much debt. Between 2002 and 2006, household borrowing grew at an average annual rate of 11%, far outpacing overall economic growth. Borrowing by financial institutions grew by a 10% annualized rate. Now many of those borrowers can't pay back the loans, a problem that is exacerbated by the collapse in housing prices. They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.
At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets.
But many of the distressed assets are hard to value and there are few if any buyers. Deleveraging also feeds on itself in a way that can create a downward spiral: Trying to sell assets pushes down the assets' prices, which makes them harder to sell and leads firms to try to sell more assets. That, in turn, suppresses these firms' share prices and makes it harder for them to sell new shares to raise capital. Mr. Bernanke, as an academic, dubbed this self-feeding loop a "financial accelerator."
[annualized yield on the 3 month Treasury bill]
"Many of the CEO types weren't willing...to take these losses, and say, 'I accept the fact that I'm selling these way below fundamental value,'" said Anil Kashyap, a University of Chicago Business School economics professor. "The ones that had the biggest exposure, they've all died."
Deleveraging started with securities tied to subprime mortgages, where defaults started rising rapidly in 2006. But the deleveraging process has now spread well beyond, to commercial real estate and auto loans to the short-term commitments on which investment banks rely to fund themselves. In the first quarter, financial-sector borrowing slowed to a 5.1% growth rate, about half of the average from 2002 to 2007. Household borrowing has slowed even more, to a 3.5% pace.
Goldman Sachs Group Inc. economist Jan Hatzius estimates that in the past year, financial institutions around the world have already written down $408 billion worth of assets and raised $367 billion worth of capital.
But that doesn't appear to be enough. Every time financial firms and investors suggest that they've written assets down enough and raised enough new capital, a new wave of selling triggers a reevaluation, propelling the crisis into new territory. Residential mortgage losses alone could hit $636 billion by 2012, Goldman estimates, triggering widespread retrenchment in bank lending. That could shave 1.8 percentage points a year off economic growth in 2008 and 2009 -- the equivalent of $250 billion in lost goods and services each year.
"This is a deleveraging like nothing we've ever seen before," said Robert Glauber, now a professor of Harvard's government and law schools who came to Washington in 1989 to help organize the savings and loan cleanup of the early 1990s. "The S&L losses to the government were small compared to this."
Hedge funds could be among the next problem areas. Many rely on borrowed money to amplify their returns. With banks under pressure, many hedge funds are less able to borrow this money now, pressuring returns. Meanwhile, there are growing indications that fewer investors are shifting into hedge funds while others are pulling out. Fund investors are dealing with their own problems: Many have taken out loans to make their investments and are finding it more difficult now to borrow.
That all makes it likely that more hedge funds will shutter in the months ahead, forcing them to sell their investments, further weighing on the market.
Debt-driven financial traumas have a long history, from the Great Depression to the S&L crisis to the Asian financial crisis of the late 1990s. Neither economists nor policymakers have easy solutions. Cutting interest rates and writing stimulus checks to families can help -- and may have prevented or delayed a deep recession. But, at least in this instance, they don't suffice.
In such circumstances, governments almost invariably experiment with solutions with varying degrees of success. President Franklin Delano Roosevelt unleashed an alphabet soup of new agencies and a host of new regulations in the aftermath of the market crash of 1929. In the 1990s, Japan embarked on a decade of often-wasteful government spending to counter the aftereffects of a bursting bubble. President George H.W. Bush and Congress created the Resolution Trust Corp. to take and sell the assets of failed thrifts. Hong Kong's free-market government went on a massive stock-buying spree in 1998, buying up shares of every company listed in the benchmark Hang Seng index. It ended up packaging them into an exchange-traded fund and making money.
Today, Mr. Bernanke is taking out his playbook, said NYU economist Mr. Gertler, "and rewriting it as we go."
Merrill Lynch & Co.'s emergency sale to Bank of America Corp. last weekend was an example of the perniciousness and unpredictability of deleveraging. In the past year, Merrill had hired a new chief executive, written off $41.4 billion in assets and raised $21 billion in equity capital.
But Merrill couldn't keep up. The more it raised, the more it was forced to write off. When Merrill CEO John Thain attended a meeting with the New York Fed and other Wall Street executives last week, he saw that Merrill was the next most vulnerable brokerage firm. "We watched Bear and Lehman. We knew we could be next," said one Merrill executive. Fearful that its lenders would shut the firm off, he sold to Bank of America.
Traders on the floor of the New York Stock Exchange Wednesday. Expectations for a quick end to the crisis are fading fast.
This crisis is complicated by innovative financial instruments that Wall Street created and distributed. They're making it harder for officials and Wall Street executives to know where the next set of risks is hiding and also contributing to the crisis's spreading impact.
Swaps Game
The latest trouble spot is an area called credit-default swaps, which are private contracts that let firms trade bets on whether a borrower is going to default. When a default occurs, one party pays off the other. The value of the swaps rise and fall as the market reassesses the risk that a company won't be able to honor its obligations. Firms use these instruments both as insurance -- to hedge their exposures to risk -- and to wager on the health of other companies. There are now credit-default swaps on more than $62 trillion in debt, up from about $144 billion a decade ago.
One of the big new players in the swaps game was AIG, the world's largest insurer and a major seller of credit-default swaps to financial institutions and companies. When the credit markets were booming, many firms bought these instruments from AIG, believing the insurance giant's strong credit ratings and large balance sheet could provide a shield against bond and loan defaults. AIG believed the risk of default was low on many securities it insured.
As of June 30, an AIG unit had written credit-default swaps on more than $446 billion in credit assets, including mortgage securities, corporate loans and complex structured products. Last year, when rising subprime-mortgage delinquencies damaged the value of many securities AIG had insured, the firm was forced to book large write-downs on its derivative positions. That spooked investors, who reacted by dumping its shares, making it harder for AIG to raise the capital it increasingly needed.
Credit default swaps "didn't cause the problem, but they certainly exacerbated the financial crisis," said Leslie Rahl, president of Capital Market Risk Advisors, a consulting firm in New York. The sheer volume of CDS contracts outstanding -- and the fact that they trade directly between institutions, without centralized clearing -- intertwined the fates of many large banks and brokerages.
Few financial crises have been sorted out in modern times without massive government intervention. Increasingly, officials are coming to the conclusion that even more might be needed. A big problem: The Fed can and has provided short-term money to sound, but struggling, institutions that are out of favor. It can, and has, reduced the interest rates it influences to attempt to reduce borrowing costs through the economy and encourage investment and spending.
But it is ill-equipped to provide the capital that financial institutions now desperately need to shore up their finances and expand lending.
Resolution Trust Scenario
In normal times, capital-starved companies usually can raise money on their own. In the current crisis, a number of big Wall Street firms, including Citigroup Inc., have turned to sovereign-wealth funds, the government-controlled pools of money.
But both on Wall Street and in Washington, there is increasing expectation that U.S. taxpayers will either take the bad assets off the hands of financial institutions so they can raise capital, or put taxpayer capital into the companies, as the Treasury has agreed to do with mortgage giants Fannie Mae and Freddie Mac.
One proposal was raised by Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee. Rep. Frank is looking at whether to create an analog to the Resolution Trust Corp., which took assets from failed banks and thrifts and found buyers over several years.
"When you have a big loss in the marketplace, there are only three people that can take the loss -- the bondholders, the shareholders and the government," said William Seidman, who led the RTC from 1989 to 1991. "That's the dance we're seeing right now. Are we going to shove this loss into the hands of the taxpayers?"
The RTC seemed controversial and ambitious at the time. Any version today would be even more complex. The RTC dispensed mostly of commercial real estate. Today's troubled assets are complex debt securities -- many of which include pieces of other instruments, which in turn include pieces of others, many steps removed from the actual mortgages or consumer loans on which they are based. Unraveling these strands will be tedious and getting at the underlying collateral, difficult.
In the early stages of this crisis, regulators saw that their rules didn't fit the rapidly changing financial system they were asked to oversee. Investment banks, at the core of the crisis, weren't as closely monitored by the Securities and Exchange Commission as commercial banks were by their regulators.
The government has a system to close failed banks, created after the Great Depression in part to avoid sudden runs by depositors. Now, runs happen in spheres regulators may not fully understand, such as the repurchase agreement, or repo, market, in which investment banks fund their day-to-day operations. And regulators have no process for handling the failure of an investment bank like Lehman Brothers Holdings Inc. Insurers like AIG aren't even federally regulated.
Regulators have all but promised that more banks will fail in the coming months. The Federal Deposit Insurance Corp. is drawing up a plan to raise the premiums it charges banks so that it can rebuild the fund it uses to back deposits. Examiners are tightening their leash on banks across the country.
Pleasant Mystery
One pleasant mystery is why the crisis hasn't hit the economy harder -- at least so far. "This financial crisis hasn't yet translated into fewer...companies starting up, less research and development, less marketing," Ivan Seidenberg, chief executive of Verizon Communications, said Wednesday. "We haven't seen that yet. I'm sure every company is keeping their eyes on it."
At 6.1%, the unemployment rate remains well below the peak of 7.8% in 1992, amid the S&L crisis.
In part, that's because government has reacted aggressively. The Fed's classic mistake that led to the Great Depression was that it tightened monetary policy when it should have eased. Mr. Bernanke didn't repeat that error. And Congress moved more swiftly to approve fiscal stimulus than most Washington veterans thought possible.
In part, the broader economy has held mostly steady because exports have been so strong at just the right moment, a reminder of the global economy's importance to the U.S. And in part, it's because the U.S. economy is demonstrating impressive resilience, as information technology allows executives to react more quickly to emerging problems and -- to the discomfort of workers -- companies are quicker to adjust wages, hiring and work hours when the economy softens.
But the risk remains that Wall Street's woes will spread to Main Street, as credit tightens for consumers and business. Already, U.S. auto makers have been forced to tighten the terms on their leasing programs, or abandon writing leases themselves altogether, because of problems in their finance units. Goldman Sachs economists' optimistic scenario is a couple years of mild recession or painfully slow economy growth.
Realtors Aiming for Full Rebound in 2009
Arlington Sun-Gazette, September 15, 2008
By BRIAN TROMPETER
The U.S. economy will continue struggling through the fourth quarter of this year, but rebound steadily next year, George Mason University economics professor Stephen Fuller predicted on Sept. 11 at the Northern Virginia Association of Realtors' 12th Annual Economic Summit.
The heavily government-supported Washington-area economy likely will not suffer as much as other parts of the country, he said.
“We won't get any whiplash,” said Fuller, who also is director of the university's Center for Regional Analysis.
The Washington region gradually is slimming down its excess housing inventory and will pass the peak of its foreclosure difficulties around Halloween, Fuller said.
The housing market downturn - especially in the reduced rate of new housing construction - has been a key factor in the nation's ongoing economic problems, he said.
Real estate in recent years was treated as a commodity, rather than a long-term investment, and this led to overbuilding and price inflation, Fuller said.
“We changed how we thought,” he said. “This is like going to a banquet and overeating. The next morning, or sometimes even the same night, I regret it. It takes a long while to work off the consequences.”
The Washington area added 35,400 new jobs between July 2007 and July 2008. This figure is lower than the average 45,000-job increase and is due to a loss of retail, construction and financial-services positions, Fuller said.
National unemployment numbers have not been encouraging. About 400,000 fewer people are employed at full-time jobs now than at this time last year, he said.
While consumer expectations have been lower ever since the last presidential election, those numbers have ticked slightly upward of late, he said.
“There is an increase in optimism among the pessimists,” Fuller said.
John Mason, executive director of the Northern Virginia Transportation Authority, also addressed the summit, which was held at George Mason University.
Mason told the Realtors that Virginia must finance new transportation projects if it is to avoid miserable gridlock in the future.
“You can't make all your sales on Sunday morning,” Mason said.
When analyzing the area's traffic congestion, authority members decided the A-through-F rating scale just didn't cut it. They then created a new low rating of G to categorize Northern Virginia's mess, he said.
The transportation authority, made up of officials from nine participating jurisdictions, last year received permission from the Virginia General Assembly to raise about $300 million per year for transportation projects.
But the Virginia Supreme Court in late February ruled the General Assembly, constitutionally, could not delegate taxing authority to an unelected body. The transportation authority has returned most of the taxes it collected and is now reducing the scope of its operations.
Mason showed a slide of projected traffic gridlock if the General Assembly does not resolve the transportation financing question.
“I am here to tell you that without that additional dedicated funding for Northern Virginia transportation, you are going to be severely challenged as you move around Northern Virginia in the process of selling homes,” he said.
Christine Todd, CEO of the Northern Virginia Association of Realtors, said the economic summit added a “great dose of optimism” about the real estate market, which is still in the midst of a recovery.
“We can now understand that there is light at the end of the tunnel - and it's not a train,” she said. “What was especially important to me was it was documented that our economy in Northern Virginia is in really good shape. No one is going to lose any money if they buy a house in this area and hold it for several years. The economy is just too strong.”
Luis Lama, the association's immediate past chairman, said Northern Virginia's economy remains strong and its real estate market will be helped by the recent federal takeover of Fannie Mae and Freddie Mac.
“We expect a very good year next year,” Lama said. “We need the news media to reflect that to the consumer.”
By BRIAN TROMPETER
The U.S. economy will continue struggling through the fourth quarter of this year, but rebound steadily next year, George Mason University economics professor Stephen Fuller predicted on Sept. 11 at the Northern Virginia Association of Realtors' 12th Annual Economic Summit.
The heavily government-supported Washington-area economy likely will not suffer as much as other parts of the country, he said.
“We won't get any whiplash,” said Fuller, who also is director of the university's Center for Regional Analysis.
The Washington region gradually is slimming down its excess housing inventory and will pass the peak of its foreclosure difficulties around Halloween, Fuller said.
The housing market downturn - especially in the reduced rate of new housing construction - has been a key factor in the nation's ongoing economic problems, he said.
Real estate in recent years was treated as a commodity, rather than a long-term investment, and this led to overbuilding and price inflation, Fuller said.
“We changed how we thought,” he said. “This is like going to a banquet and overeating. The next morning, or sometimes even the same night, I regret it. It takes a long while to work off the consequences.”
The Washington area added 35,400 new jobs between July 2007 and July 2008. This figure is lower than the average 45,000-job increase and is due to a loss of retail, construction and financial-services positions, Fuller said.
National unemployment numbers have not been encouraging. About 400,000 fewer people are employed at full-time jobs now than at this time last year, he said.
While consumer expectations have been lower ever since the last presidential election, those numbers have ticked slightly upward of late, he said.
“There is an increase in optimism among the pessimists,” Fuller said.
John Mason, executive director of the Northern Virginia Transportation Authority, also addressed the summit, which was held at George Mason University.
Mason told the Realtors that Virginia must finance new transportation projects if it is to avoid miserable gridlock in the future.
“You can't make all your sales on Sunday morning,” Mason said.
When analyzing the area's traffic congestion, authority members decided the A-through-F rating scale just didn't cut it. They then created a new low rating of G to categorize Northern Virginia's mess, he said.
The transportation authority, made up of officials from nine participating jurisdictions, last year received permission from the Virginia General Assembly to raise about $300 million per year for transportation projects.
But the Virginia Supreme Court in late February ruled the General Assembly, constitutionally, could not delegate taxing authority to an unelected body. The transportation authority has returned most of the taxes it collected and is now reducing the scope of its operations.
Mason showed a slide of projected traffic gridlock if the General Assembly does not resolve the transportation financing question.
“I am here to tell you that without that additional dedicated funding for Northern Virginia transportation, you are going to be severely challenged as you move around Northern Virginia in the process of selling homes,” he said.
Christine Todd, CEO of the Northern Virginia Association of Realtors, said the economic summit added a “great dose of optimism” about the real estate market, which is still in the midst of a recovery.
“We can now understand that there is light at the end of the tunnel - and it's not a train,” she said. “What was especially important to me was it was documented that our economy in Northern Virginia is in really good shape. No one is going to lose any money if they buy a house in this area and hold it for several years. The economy is just too strong.”
Luis Lama, the association's immediate past chairman, said Northern Virginia's economy remains strong and its real estate market will be helped by the recent federal takeover of Fannie Mae and Freddie Mac.
“We expect a very good year next year,” Lama said. “We need the news media to reflect that to the consumer.”
Mortgage Q&A: Federal Bailout Results
Washington Times, September 12, 2008
By Henry Savage
Most readers undoubtedly have heard about the federal government's takeover of mortgage giants Freddie Mac and Fannie Mae. While many in the media are lamenting the decision as another costly government bailout, I thought I would take this opportunity to explain what it all means and how it could affect the average American.
First, let me explain what Fannie Mae and Freddie Mac do, as many folks have no idea. They are nicknames for the Federal National Mortgage Corp. and the Federal Home Loan Mortgage Corp. Both of these companies were chartered by the federal government with a design to provide mortgage money to as many Americans as possible. Here's how these companies work.
Before the establishment of Fannie and Freddie, Americans would obtain their mortgages from local banks and so-called building and loan associations. These banks would take savings deposits, pay out an interest rate and then turn around and lend mortgage money to homeowners at a higher interest rate.
The problem is that a bank would run out of money to lend because it had a limited amount of savings deposits from its customers. Enter Fannie Mae and Freddie Mac.
Fannie and Freddie would purchase the loans from the bank, freeing up cash so the bank could make new loans. Fannie and Freddie then would package their loans into mortgage-backed-securities and sell them to investors. Investors would enjoy a nice return on an asset that was collateralized by residential real estate.
Fannie and Freddie established underwriting standards that each loan applicant must meet. It is the lender's responsibility to ensure that each loan applicant meets Fannie's and Freddie's criteria or risk having the loan be rejected for purchase.
This arrangement worked quite well for many years. As interest rates dropped and property values rose beginning in the 1990s, Fannie and Freddie relaxed their guidelines and began to offer so-called Alt-A mortgages. Those programs carried slightly higher rates and were offered to folks who didn't quite fit the conventional guidelines.
Meanwhile, direct lenders and Wall Street investors teamed up to offer subprime loans. Those carried far higher rates and were offered to folks with no down payment and poor credit. Lenders and mortgage investors didn't worry because property values kept rising. If the borrower got into trouble, he simply could sell his house, pay back the mortgage and take a profit.
Am I painting the picture of a train wreck waiting to happen?
Here's the perfect storm: Property values fall, subprime loan holders owe more than the properties are worth, teaser interest rates expire, and balloon payments come due. Delinquencies and foreclosures rise, and mortgage investors get stuck with the hot potato.
Once Wall Street got burned, it lost its appetite for mortgage-backed securities, creating the credit crunch. Meanwhile, Fannie and Freddie get stuck with mortgage paper they can't sell during a period of skyrocketing delinquency and foreclosure rates.
One of the byproducts of this mess is a combined loss of $14 billion for Fannie and Freddie in the past year.
So the Feds decide they had better spend some taxpayer money and prop up these two giants to avert an economic catastrophe. No one really knows how much the bailout will cost the American taxpayers, but the consensus is it depends upon Fannie's and Freddie's financial performance in the coming years.
What does this mean for future homeowners and those who want to refinance their loans? As part of the bailout, the Treasury Department has agreed to purchase Fannie's and Freddie's mortgage-backed securities in the open market, alleviating the credit crunch.
It also should bring down mortgage rates. It's anyone's guess as to how low rates may go, but rates dropped about three-eighths of a percent in the first day after the announcement.
If the trend continues, potential home buyers will see more affordable housing and homeowners will be able to save some money by lowering their interest rate through a refinance.
By Henry Savage
Most readers undoubtedly have heard about the federal government's takeover of mortgage giants Freddie Mac and Fannie Mae. While many in the media are lamenting the decision as another costly government bailout, I thought I would take this opportunity to explain what it all means and how it could affect the average American.
First, let me explain what Fannie Mae and Freddie Mac do, as many folks have no idea. They are nicknames for the Federal National Mortgage Corp. and the Federal Home Loan Mortgage Corp. Both of these companies were chartered by the federal government with a design to provide mortgage money to as many Americans as possible. Here's how these companies work.
Before the establishment of Fannie and Freddie, Americans would obtain their mortgages from local banks and so-called building and loan associations. These banks would take savings deposits, pay out an interest rate and then turn around and lend mortgage money to homeowners at a higher interest rate.
The problem is that a bank would run out of money to lend because it had a limited amount of savings deposits from its customers. Enter Fannie Mae and Freddie Mac.
Fannie and Freddie would purchase the loans from the bank, freeing up cash so the bank could make new loans. Fannie and Freddie then would package their loans into mortgage-backed-securities and sell them to investors. Investors would enjoy a nice return on an asset that was collateralized by residential real estate.
Fannie and Freddie established underwriting standards that each loan applicant must meet. It is the lender's responsibility to ensure that each loan applicant meets Fannie's and Freddie's criteria or risk having the loan be rejected for purchase.
This arrangement worked quite well for many years. As interest rates dropped and property values rose beginning in the 1990s, Fannie and Freddie relaxed their guidelines and began to offer so-called Alt-A mortgages. Those programs carried slightly higher rates and were offered to folks who didn't quite fit the conventional guidelines.
Meanwhile, direct lenders and Wall Street investors teamed up to offer subprime loans. Those carried far higher rates and were offered to folks with no down payment and poor credit. Lenders and mortgage investors didn't worry because property values kept rising. If the borrower got into trouble, he simply could sell his house, pay back the mortgage and take a profit.
Am I painting the picture of a train wreck waiting to happen?
Here's the perfect storm: Property values fall, subprime loan holders owe more than the properties are worth, teaser interest rates expire, and balloon payments come due. Delinquencies and foreclosures rise, and mortgage investors get stuck with the hot potato.
Once Wall Street got burned, it lost its appetite for mortgage-backed securities, creating the credit crunch. Meanwhile, Fannie and Freddie get stuck with mortgage paper they can't sell during a period of skyrocketing delinquency and foreclosure rates.
One of the byproducts of this mess is a combined loss of $14 billion for Fannie and Freddie in the past year.
So the Feds decide they had better spend some taxpayer money and prop up these two giants to avert an economic catastrophe. No one really knows how much the bailout will cost the American taxpayers, but the consensus is it depends upon Fannie's and Freddie's financial performance in the coming years.
What does this mean for future homeowners and those who want to refinance their loans? As part of the bailout, the Treasury Department has agreed to purchase Fannie's and Freddie's mortgage-backed securities in the open market, alleviating the credit crunch.
It also should bring down mortgage rates. It's anyone's guess as to how low rates may go, but rates dropped about three-eighths of a percent in the first day after the announcement.
If the trend continues, potential home buyers will see more affordable housing and homeowners will be able to save some money by lowering their interest rate through a refinance.
Subscribe to:
Posts (Atom)
