Housing Recovery?

Housing Recovery?

We are in a housing recovery, yay!   Not so fast there Mr. Headline.  Before we get too giddy about the happy run up in home prices, we need to assess some important fundamentals. House prices across the spectrum are heavily dependent on first-time home buyers. The first-timer buys a home from an existing homeowner who is then able to purchase a more expensive home, which allows that homeowner to buy an even more expensive home and so on. Over the past 30 years, first-time home buyers represented 40% of existing home sales. According to the National Association of Realtors, in June of 2013, first-time buyers represented only 29% which was a drop from 32% a year earlier. Why this deviation from historical norms? First-timers are typically younger than existing homeowners. In today’s market, younger workers have a higher unemployment rate than the overall workforce and are also saddled with much larger student loans than in the past. Their required payments on these loans reduce how much of a mortgage they can afford, their ability to save up for a down payment and lower their credit score.


  • In August, sales of new single-family homes dropped to their lowest level since last October, according to the department of Housing and Urban Development.
  • The Mortgage Banker Association reported that their mortgage application index just fell 13.5% from the week ended September 6th, reaching a five-year low.
  • Median household income, which greatly affects home affordability thus prices, was $52,098 in June 2013. That’s still down significantly from the start of the recession in December 2007 when it was $55,480. (Both figures adjusted for inflation)
  • Now for one heck of a head scratcher! Interest rates on jumbo mortgages, which are too big for government backing, have historically been at higher rates than conforming loans, which are back by Fannie Mae, Freddie Mac or other government agencies. At the end of August the relationship flipped, putting the interest rate on larger mortgages that lack government backing lower! This is the first time in history that this has happened, further highlighting the dramatic impact of the recent sharp rise in interest rates.


Bottom Line: Until youth unemployment and the mind-boggling rise in tuition fees are addressed, home prices will continue to face limiting headwinds. In addition, there have only been 16 periods in the past 50 years when interest rates rose more than 20% in 200 days. The recent rise in rates has been dramatic on a percentage basis. Be wary of the impact on housing.

New Home Refinancing Plan Steals from Piggy Banks to Boost Prices

On February 8th Lenore Hawkins joined the Freedom Fighters to discuss a new proposal to aid the struggling housing market and the recent push to include Fannie Mae and Freddie Mac in the federal budget.

President Obama wants a sweeping new program to help more struggling homeowners refinance their mortgages at lower interest rates, but there’s an important detail – a fee Uncle Sam will likely charge homeowners for the government’s help. The President proposed lowering monthly payments for millions of homeowners by refinancing their loans through the Federal Housing Administration. The agency provides insurance against default for banks that make riskier loans mainly to borrowers who make small down payments. FHA currently tacks 1.15% on top of the interest rate of new mortgages it guarantees. While the Administration has not yet decided how to structure charges this new refi program, a fee of that size could reduce savings for borrowers and make it less cost effective for the borrower. To help pay for this plan, the President proposed a new fee on big banks. It would raise $5 billion to $10 billion a year to subsidize premiums–“a big chunk of the cost,” the administration official said. The subsidies would help keep the program affordable, he said–and attractive to as many eligible borrowers as possible.

  • This is all about trying to boost up the prices of homes to give people the impression that they are better off, but it is yet another example of government getting cause and effect all messed up AND taking money away from one group and giving it to another.
  • Keep in mind that this refinancing would harm the owners of mortgage bonds, which are primarily mutual funds, pensions and real estate investment trusts.  So in order to try and boost the price of my home, the government is going to raid my savings!

On to the efficacy of the program:

  • The price of anything is determined by supply and demand.
  • The demand for housing is a function of 3 things:  Household income, stability of that income (will you need to move/ will your paychecks keep coming) and interest rates.
  • From 1999 to 2007 Median the median home price rose 54% while median household income FELL 1%.  Prices skyrocketed while the ability to pay fell?  Why?
  • Interest rates and the availability of credit expanded.  Houses were no longer purchased to become a home, but rather as a fail-safe investment.   This drove demand well beyond what it should have been.
  • The exploding demand induced a construction boom.  Now we have more homes that the economy can support.
  • Unemployment may have fallen to 8.3%, but that is a misleading indicator.  The employed as a percent of the population bottomed at 58.2% in Dec 2009 and is now only 58.5%.  0.3% increase since the depths of the recession.  Meanwhile household income has continued to fall, even after the end of the recession and is now 14.2% below the 2009 peak.
  • The housing problem can only be solved by 1, letting the excess supply get worked out and 2, a growing economy in which household income rises.  No amount of government manipulation of interest rates and the supply of loans can, over the long run, counter the gravity-like reality of simple supply and demand.

Adding Fannie and Freddie to the National Books

House lawmakers passed legislation Tuesday to put the operations of Fannie Mae and Freddie Mac on the federal budget to more accurately reflect the costs of their rescue. When the government took over Fannie and Freddie through a legal process known as conservatorship, the Bush administration opted against incorporating the companies’ obligations into the federal budget, citing the arrangement’s “temporary nature.” The President’s administration has maintained that policy, accounting for Fannie and Freddie as entities that are independent from the government but receive regular infusions of cash. Critics, however, argue that this arrangement doesn’t reflect reality.

  • In 1990, federally backed loans made up roughly 50% of all loan originations.  For the past 3 years, they’ve been over 90% of all loan originations.
  • Home prices continue to fall, according to a Case-Shiller report prices fell another 3.7% in November (the most recent report).
  • Fannie and Freddie simply transfer the risk of mortgage default from the lender to the taxpayer.
  • Although the U.S. government needs very much to get out of the home loan business, it is not reasonable for this to happen anytime soon as it would be entirely too disruptive to an already fragile and critical part of the economy.
  • The most likely solution for Fannie and Freddie is to have them slowly wind down their loans, which means they will be on the books for a considerable period of time, thus their financials need to be integrated with the rest of the federal government.
  • Ultimately taxpayers and the U.S. economy will only be protected from future bailouts by a full withdrawal of the federal government from housing policy.  Interventions by the FHA, Fannie, Freddie, Federal Home Loan banks etc continue to push excess capital into the housing markets, making the commercial banking sector overly vulnerable to downturns in the housing market.
We Aren't Out of the Woods Yet

We Aren't Out of the Woods Yet

The growth of an economy is dependent primarily on just two factors, (1) the quantity and quality of the labor pool and (2) the amount of available investment capital. With the current unemployment rate, clearly the quantity of the labor pool is not a problem. The quality of that pool is a discussion for another time. So what about the amount of available investment capital? The talk in the investment world is about QE2, and unfortunately they aren’t referring to the Cunard ocean liner. QE2 refers to the second round of “Quantitative Easing” by the Federal Reserve, which is a politically savvy way of describing the Fed printing money. (Please see “U.S. Banking System” on this blog for more details.) At its November 3rd meeting, the Fed is expected to announce the launch of QE2. Expectations are for an initial level of $500 billion, with room for upward revisions. Last week Goldman Sachs opined that $4 trillion is quite possible, according to their analysis using the Taylor Rule, which is a measure of inflation, GDP and the impact of Fed rate cuts. This rule has been fairly spot on so far in tracking the Fed’s rate decisions so their analysis warrants attention.
When credit contracts, the economy is contracting, when credit expands, the economy is expanding. The Fed is hoping that by increasing banks’ ability to lend, it can jump start the economy. Mr. Bernanke is a bit like 49er and Charger fans in the 4th quarter. This time it will be different! Anyone who saw the 49er and Charger games on October 24th understands our pain. For credit to expand, borrowers need to want to borrow, and banks need to want to lend. According to an August 23, 2010 article in the Wall Street Journal, non-financial companies in the S&P 500 are sitting on a record $2 trillion in cash.  Doesn’t sound like the problem is that businesses are lacking the funds necessary to expand, now does it? So what about existing bank reserves? This chart, using data from the Federal Reserve, shows that bank reserves are at record highs, so that seems unlikely as well.

Both corporate and household lending rates are at historical lows. So the lack of borrowing can’t be because the interest rates are too high, yet the Fed is intent on lowering these already historically low rates. Be wary as history shows that excessively low interest rates inevitably lead to asset bubbles as those who have cash desperately seek some place to generate returns.

Household income is showing slight improvements, savings is trending up while spending is trending down. This doesn’t seem to indicate a desire by households to borrow. (The following chart is derived from Data from the U.S. Department of Commerce, Bureau of Labor Statistics)

What is QE2 likely to accomplish? The Fed will once again create money out of thin air and most likely use it to purchase Treasury bonds to send long-term interest rates even lower. If this works, bond yields should fall, the dollar will fall and stocks and commodities should rise. A good deal of this has already been “baked in” to the market, meaning since the markets are convinced Bernanke is going for round two, they’ve already adjusted as if it were a done deal. Shorting the dollar has become a favorite pastime of many market professionals, so we could even see a rally in the dollar if QE2 doesn’t come on as strong initially as some have predicted. In the short run, things could go in a variety of directions, all of which are becoming increasingly difficult to anticipate. In the long run, inflation and potentially high inflation is a real possibility with all this expansion of bank reserves. I recently attended a meeting of the Mont Pelerin Society, (an international organization composed of economists, Nobel Prize winners, philosophers, historians, and business leaders) in Sydney, Australia. A topic of discussion at this conference was the possible destructive consequence of the developed nations’ seeming race towards the bottom through currency debasement. The investing world is becoming a more challenging jungle to navigate as the actions of individuals in governments around the world have increasing impact on the global economy, rather than market fundamentals. This past weekend the finance ministers of the G20 countries met in Korea to discuss “re-balancing the world.” When 20 fallible human bureaucrats, with imperfect knowledge under great political pressure try to impact the world, it usually doesn’t turn out well. For investors a defensive position that does not rely on strong GDP growth or economic stability is in our opinion, a wise choice.

Now how about those banks that Bernanke wants to nudge along with increased reserves? This past week PIMCO, Black Rock, Freddie Mac, the New York Fed, and Neuberger Berman Europe, LTD., collectively sued Countrywide for not putting back bad mortgages to its parent, Bank of America. This is surely the first in a series of suits aimed at getting control of the mortgage-backed security portfolios. Then there is the testimony from Mr. Richard Bowen, former chief underwriter with CitiMortgage given in April to the Financial Crisis Inquiry Commission Hearing on Subprime Lending and Securitization and Government Sponsored Enterprises, (why are government activities always so wordy!?). He stated that, “In mid-2006 I discovered that over 60% of these mortgages purchased and sold were defective. Because Citi had given reps and warrants to the investors that the mortgages were not defective, the investors could force Citi to repurchase many billions of dollars of these defective assets….We continued to purchase and sell to investors even larger volumes of mortgages through 2007. And defective mortgages increased during 2007 to over 80% of production.” Does anyone really believe that Citibank was the only one up to this mischief, and we use the term mischief generously! We could see substantial level of lawsuits launched against these institutions, which would further serve to undermine an already weakened economy.

As for the banking sectors’ recent financial performance, there were mixed results with Bank of America posting a $7.3 billion loss in the third quarter and Goldman Sachs profit down 40% and Morgan Stanley’s profits fell 67%. Regional banks have shown some positive results, but smaller banks continue to close. There have been more than 300 bank failures since the recession began with 132 this year alone. There is considerable opportunity in the banking sector for mergers and acquisitions and all this tumult provides some opportunities, but again, defensive posturing is the name of the game for those investors who want to be successful in the long run.

Consumer confidence, which improved to August to 53.2, dropped to 48.5 in September. According to Lynn Franco, Directors of the Conference Board Consumer Research Center: “September’s pull-back in confidence was due to less favorable business and labor market conditions, coupled with a more pessimistic short-term outlook. Overall, consumers’ confidence in the state of the economy remains quite grim. And, with so few expecting conditions to improve in the near term, the pace of economic growth is not likely to pick up on the coming months.”

Is there any hope? I attended an investment conference in July where Niels Veldhuis of the Fraser Institute discussed the Canadian success story. Canada came through the recent financial crisis with no major bank failures, stronger GDP than the U.S. and the Canadian dollar is now selling at close to par against the USD. It has one of the lowest debt to GDP ratios among industrial nations and one of the fastest economic growth rates since adopting fiscal reforms in 1995. The Heritage Foundation/WSJ Economic Freedom Index ranks Canada No. 7, the U.S. is now at No. 11.

In 1995 Canada faced a crisis similar to the one facing the U.S. today with a downward spiraling currency, huge deficits, a tripling of the national debt since 1965, ballooning entitlements, government spending approaching 53% of GDP, and rampant inflation. The government cut spending by 10% over two years, laid off 60,000 federal workers over three years and eliminated the deficit in two years. For the next 11 years they ran a surplus, cut the national debt in half and reduced the size of government from 53% of GDP to today’s 39% all without raising taxes.

There is hope, but it will require discipline and an end to kick the can down the road solutions. We are positioning our clients to be able to take advantage of and be protected from the inevitable volatility as sovereign nations take actions that are impossible to predict in addressing their economic and financial problems. We are also cognizant of and prepared for impending inflation, that while unlikely in the short-term is highly likely in the longer-term and will be devastating for those who are not prepared.


Gross Domestic Product (GDP): GDP dropped to 1.7% annualized rate in Q2 from 3.7% in Q1 and 5.0% in Q4 of 2009. GDP is expected to remain at 1.5% in Q3 and drop to 1.2% in Q4. Traditional buy-and-hold strategies struggle with such dismal growth prospects.

Unemployment continues to be the biggest economic concern and appears to be stagnating. The Bureau of Labor Statistics reported a rate of 9.6% in September with the number of unemployed persons at 14.8 million, essentially unchanged from August. There are currently 1.2 million discouraged workers, defined as persons not currently looking for work because they believe no jobs are available for them, which has increased by a staggering 503,000 over the past year.

Housing: Mortgage rates have dropped nearly 1% in the past year to a historic low of 4.42% for the 30-year, yet existing home sales dropped a record 27% (measured month-over-month) to an all time low, since data tracking began in 1999, of 3.83 million units at an annual rate. If record low rates cannot stimulating housing, pay attention!

Market Volume: CNBC recently reported that currently 90% of all trading volume in the markets is in 5% of the stocks. This means that a very small number of stocks are moving to manipulate the indices, which calls in question the meaning of the trends. In addition, the majority of the trading that is taking place is now generated by high-frequency computers and these programs can enter more orders in one second than a whole trading room of traders can enter in a month. Just one more reason to maintain a defensive portfolio.

Recovery or is the worst yet to come?

Recovery or is the worst yet to come?

I attended FreedomFest last week in Las Vegas where I had the pleasure of meeting incredible people like Steve Forbes, John Mackey, Mark Skousen, Burt Malkiel, Stephen Moore, and Nathaniel Brandon, and caught up with some folks from the Cato Institute that I’m honored to call friends, Dan Mitchell and Richard Rahn.  The big question these days is, “Are we in a recovery, or is the worst yet to come?”  This was much talked about, and in a shocking turn of events, I have an opinion, (note wry grin for those of you who know me well.)

To answer that question, we first need to identify how we got ourselves into this recent pickle.  There were a myriad of different factors contributing to the mess, but I would argue that one of the most significant, most fundamental was Greenspan’s addiction to low interest rates.

The artificially low interest rates induced more borrowing than would have otherwise occurred.  This resulted in projects being funded with debt that would not have been funded, had the cost of borrowing been higher.  Think of it this way, are you more likely to buy that new car with a 0% loan than a 10% loan?  Are you more likely to buy a house as an investment and flip it at a 2% rate mortgage than at 8%?  Interest rates are a bit like a sanity check.  They help clarify if something is a good idea, marginal idea or just plain bad idea.  With exceptionally low interest rates, more bad ideas get funded.  We got drunk off Greenspan’s cocktail and most everything seemed like a great idea, for clarification, see the movie The Hangover.

Now we have countless empty homes, office buildings, warehouses and factories standing as monuments to the devastation of this potent cocktail.  It isn’t easy to repurpose invested capital.  How do you repurpose a tractor or a building built in a poor location?  But the hangover doesn’t end there.  All these investments employed people.  The demand for more and more labor in these malinvestments pulled labor away from the truly good ideas and with that excess demand for labor, bid up the price of labor which at the time, seemed like one hell of a party as the paychecks rolled in.  Once the music stopped, as it inevitably must, the labor that had been misappropriated was left unemployed.

But it gets worse.  The now unemployed labor was seduced by the low rate party as well and bought homes they could not afford in a sane world, but with paychecks always going up and home values always going up, why not!?  And hell, Frannie and Freddie are eager to get you into that fantastic new 4 bedroom with a Jacuzzi tub, no questions asked, just sign here and we’ll give you the money.  Just put 5% or 0% down and equity in your home will quickly grow like crazy and voila, you have an ATM machine in the form of a home equity line.  So buy that beautiful new car, go on that luxurious vacation, you deserve it and as for savings, who would ever dream of that as the ever rising home values will be all the savings you’ll ever need!

But then the crash came…  Now people have the choice of either walking away from their home with only some damage to their credit thanks to non-recourse mortgages, or staying in a home that is deeply underwater with no jobs in site to give them hope of ever recovering from the Greenspan hangover.  Enter the Fed to use tax payer money to make the banks whole on all those ridiculous loans that have gone bad.  Your tax dollars hard at work ensuring that the ramifications of bad decisions are spread out among the 50% of us that actually pay taxes, while the lunatics who decided those loans were a good idea continue on as if they were the victims.

So where are we now?  Have we cleaned the bad loans out of the system, errrh, no.   Have we returned interest rates to anything near sanity, hmmm, no.  So where are we then?

  1. Unknown level of bad loans still outstanding with a kick the can mentality.  Mortgages still messy and we have yet to work through the commercial real estate fiasco.  Be wary.  Opportunity abounds, but these are shark infested waters.
  2. Significant excess production capacity built up during a seriously overheated market continues.  Not good for growth – don’t need to invest in new capital with over capacity and less labor is required.
  3. Continued high unemployment.  It is generally estimated that 125,000 new hires per month are necessary to provide jobs for the growing labor market.  If we want to get the eight million or so that lost their jobs in the past 18 months back to work within the next three years, that’s another 230,000 new jobs per month as well, meaning we need 355,000 jobs added per month to get back to full employment within 3 years.  Don’t hold your breath.  P.S. The Health Care Reform bill, which makes labor more expensive makes this even more unlikely.
  4. Deficit spending has given our nation a higher and higher debt load, with little growth in GDP to pay for it.  We keep increasing our nation’s mortgage at an alarming rate, while the paycheck is barely growing.  This is unsustainable at best and hamstrings the private sector from growing GDP.
  5. We are set to have the largest tax increase in our nation’s history on January 1st, 2011, which will put a big wet blanket on growth.  We’ve all heard the mantra, you cannot tax your way to prosperity.
  6. We have a now relatively impotent Fed, in that interest rates cannot realistically go any lower.  We’ve dropped rates and spent like drunken sailors with a barely perceptible effect!  I guess that just means we need to double down and spend more.  If you wake up with a hangover, it is because you stopped drinking too soon you fool!
  7. Increased regulation and sporadic and unpredictable application of the now frighteningly flexible law has left businesses wary of making any growth plans.  It is better to hunker down, grow your cash balance and keep a wary eye out.


So are we headed for another downturn?  Quite likely I’d say.  At the very least, don’t expect strong GDP growth in the near future.  Do expect continued volatility as politicians around the globe flail about trying to save their jobs, acting ever more irrational and unpredictable.

The Role of Regulations in the 2008 Financial Crisis

The Unintended Consequences of Regulation and Subsidies

My apologies for the length of this piece, but this is a complex topic and I’ve had a lot of coffee!

In our investment practice, we use tactical asset allocation to vary the mix of assets in a portfolio in response to changing prices, economic and business conditions.  We believe this will both reduce the investment rollercoaster ride and provide opportunities for better returns over time.  We believe that valuation matters most, so we first determine whether an asset class is currently cheap, expensive or fairly priced.  If you pay too much for an investment, all the time in the world won’t fix it, contrary to many popular how-to investment books.  We also believe that we cannot forecast the future, but we can make judgments on whether the macro economic conditions are favorable or unfavorable for a particular asset class and adjust our portfolios accordingly.

Any discussion of investments invariable leads to the broader economy.  Any discussion about the economy invariably leads to politics, as governments have significant influence over the global and domestic economy.  Two of the most impactful tools governments use to impact the economy are regulations and subsidies.

Subsidies distort markets in that they artificially increase demand.  This artificial boost in demand raises prices and pushes the market to allocate more resources, (workers, money, equipment, land etc.) into the subsidized industry than it otherwise would have.  When the subsidy invariably ends, those mis-allocated resources have to go elsewhere, but the shift can take considerable time and be very painful.  In the recent housing crisis, the subsidies discussed later in this piece added a lot of workers to the payrolls of construction firms and induced investments that would have otherwise gone elsewhere.  When it all came crashing down, as it always does, those workers had to find jobs in other industries and investments were lost.

Regulations distort incentives.  Regulations are typically implemented to keep a nation’s citizens safer than is believed they would be under free markets.  This theoretical protection can range from hazardous products to foreign competition or financial irresponsibility.   Without regulations, companies will behave according to their individual views on the opportunities and risks in the marketplace.  Their views and corresponding actions may be contrary to what a regulator or regulation deems appropriate.  However, the unfettered behavior in the free markets, which some may argue is more risky, does tends to create a diversified set of positions, which helps prevent industry-wide failure.  All participants don’t put all their eggs in the same basket as companies tend to follow different tactics to gain a competitive edge.  Regulations are intended to force companies to all behave in a similar manner with respect to the regulated area, so now everyone has their eggs in the same basket.  Thus the industry as a whole may be more vulnerable to systemic changes that are not anticipated by the regulation.

Regulations played a significant, although not widely discussed role in the recent financial crisis.  We watch for these distortions in the market place, among others, and adjust our clients’ portfolios accordingly to both protect from and take advantage of the “bubbles” they can cause.

The recent financial crisis was impacted in a large part by a series of well meaning regulations and subsidies designed to make home ownership more widespread and banks stronger.  When piled on top of each other, the combination created a whopper of unintended consequences.  In order to keep this piece as short as possible, I am only discussing what I believe to be the primary regulations and subsidies involved in the recent financial crisis.  Any omission is in the interest of brevity.  There are other factors involved in the recent crisis, but the ones discussed here are noteworthy and I believe have been overlooked by many.

By subsidizing housing with low cost loans, low down payments, and increased access for sub-prime borrowers, good intentions pushed housing prices into the stratosphere.

Increasing home ownership for low income earners has long been a mission for the Federal Housing Authority.  This sounds like a fantastic goal as what politician would say they don’t want families to own their homes?  The problem is that by subsidizing something, you increase the demand for it by effectively lowering the purchase price.  Increase demand and prices go up!  The Federal Housing Authority (FHA) insured around one million no-down payment mortgages in each fiscal year from 1998 to 2001 (England 2002, 73).

Traditionally non-FHA mortgages required a minimum of 20% down, but in 1994, the Department of Housing and Urban Development (HUD) ordered Fannie Mae and Freddie Mac to supplement and eventually to far surpass the FHA’s efforts, by directing 30% of their mortgages to low-income borrowers, which lead Fannie Mae to introduce 3% down mortgages in 1997.   In 2000, HUD increased the Fannie Mae and Freddie Mac low-income target to 50% of all loans! (Schwartz 2009).  In 2005, HUD increased the target again to 52%.

In 2000, Fannie launched a “ten-year, $2 trillion ‘American Dream Commitment’ to increase home ownership rates among those who previously had been unable to own homes.” (Bergsman 2004).

In 2002 Freddie Mac joined with the “Catch the Dream” program combining “aggressive consumer outreach, education, and new technologies with innovative mortgage products to meet the growing diversity of home buying needs.” (Schwartz 2009)

All these subsidies increased the supply of mortgages to low income homeowners, but what was the source of the money to fund these loans?  Welcome to the Mortgage Backed Security.  Banks would pool together mortgages that could then be sold as a mortgage backed security (MBS).  By doing this, banks could sell off the loans they’d given to homeowners and get more cash for the next set of loans.

In 1997 Bear Stearns completed the first private securitization of subprime loans that had been pulled together by First Union Capital Markets.  Normally a bond, including an MBS, needs to be rated so that investors know how secure the bond is likely to be from default.  This issuance was unrated, but since the mortgages in the pool were guaranteed by Freddie Mac, they produced an” implied AAA rating,” according to a news release from First Union.  So here we have sub-prime loans, meaning loans with a higher likelihood of default, receiving AAA ratings because they are backed by GSEs (Government Sponsored Enterprise).  A collection of subprime loans magically became low-risk because of the GSE backing.  Now that is some powerful fairy dust!

So now we have created a way to turn a pool of sub-prime mortgages into AAA rated bonds.  But why was there such incredible demand for these bonds?  For this we have to look at the Basel Accords and the ratings agencies.

In 1975 the Securities and Exchange Commission effectively conferred the three rating agencies that were then in place, (Moody’s, Fitch and Standard and Poor’s) oligopoly status by ensured that only these three firms were Nationally Recognized Statistical Rating Organizations (NRSROs) and that only an NRSRO’s ratings would fulfill a given regulatory mandate for investment-grade and AAA ratings.   Thus the success of these entities was no longer based upon the quality of their ratings, but rather the government’s protection.  Without government protection, a rating agency who published inaccurate ratings would suffer financially and potentially go out of business entirely.  Thus there was no competition among ratings agencies that could highlight potential weaknesses in their methods of the various agencies.   The 1975 ruling effectively prohibits anyone else from competing with the 3 ratings agencies for the institutional investors’ mandatory business.

We now know that these bonds should not have been receiving such high ratings.  Why did they?  The NRSROs all used models based on historical default data.  Clearly this data was relatively useless for the mortgage environment in the recent decade.  Never before in our nation’s history had government done so much to subsidize housing and never before had so many loans been given out with low or no down payment.  Without skin in the game, a homeowner is much more likely to walk away from a home that is no longer worth the debt on it!  A low or no money down mortgage effectively makes the home “owner” a renter from the bank, and can just walk away if the “rent” to home value becomes less attractive, especially in the non-recourse states.

Plenty of employees at the three ratings agencies criticized their firms’ models for risk assessment of the GSE guaranteed MBS.  If the government protection of the three NRSROs didn’t exist, these employees could have started competing firms and brought to light the errors they perceived in their former employers’ models.  With this protection, no competitor could take advantage of the three agencies’ mistakes and bring differing opinions to the market.

So why was so much of the MBS risk concentrated in the banks? The Basel Accords.

The 1988 Basel Accord required an adequately capitalized commercial bank to maintain at least 8% capital against its assets in reserve.  Reserve requirements have been around for quite a while, but Basel changed the required capital to reflect differences in risk among different types of assets owned by the banks.  Thus an asset deemed to have zero risk of default, such as a US government bond, required no reserve capital.  Commercial loans were given 100% risk weighting, thus required the full 8% capital.  Mortgages in general were given 50% risk, thus for a $100 mortgage, the bank was required to keep $100 * 8% * 50% = $4 in reserves.

Then the magic of AAA rated GSE backed bonds emerged and since Basel assigned a risk rating of only 20% to any issuance by a GSE, which includes Fannie Mae, Freddie Mac, for a $100 AAA rated GSE backed bond, a bank would only have to hold in reserves $100 * 8% * 20% = $1.60.

Here’s the insanity.  A bank issues a mortgage for $100, which would require it to hold $4 in reserves.  If it then sells that mortgage to Fannie or Freddie, then buys it back in the form of a GSE backed MBS, it would only have to hold $1.60.  This reduction is required capital reserves, which increases the bank’s leverage – its borrowing and lending power, and thus increases its potential profitability by a whopping 60%, simply by round-tripping mortgages!

These regulations explain why commercial banks found it so profitable to originate sub-prime mortgages, sell them off to Fannie and Freddie for securitization and buy them back as MBS.  If Fannie and Freddie weren’t there to buy them OR if the Basel Accords didn’t give a discount for a GSE backed securities, things might have played out very differently, despite the Fed’s artificially low interest rates.  It is interesting to note that five days before declaring bankruptcy, Lehman Brothers held a “Tier 1” capital ratio of 11%, almost three times its effective minimum requirement.

Private securitizers such as Bear Sterns, (as opposed to a bank like Wells Fargo) also became heavily involved in subprime securitization in 2002, because 10 years after the 1991 implementation of Basel I, the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision adopted the “Recourse Rule,” which added to Basel I’s assignment of 20% for GSE-issued securities the same risk weight for privately issued asset-backed securities, include MBS that had received a AA or AAA rating from an NRSRO.

Starting at the end of 2006, Basel II adopted a similar rule for the entire developed rule, thus banks anywhere in the world could dramatically reduce their reserve requirements by purchasing GSE issued or AA or AAA asset-backed securities.

So much for the financial crisis being a failure to regulate, unless by that we mean a failure FROM the regulations in place.

Lastly, was it bankers’ greed? 

It is a popular notion these days to blame the crisis on those evil bankers.  Problem with that assessment is if all this was driven by bankers’ insatiable greed, they would have purchased primarily AA ratings.  These provided exactly the same reserve benefits, but produced a higher yield: same benefit, bigger profits.  But they didn’t do that.  Of the $1.323 trillion in MBS held by banks and thrifts in 2008, 93% were either AAA rated or issued by a GSE.  (Acharaya and Schnabl 2009)  Then to get even more safety, the bankers bought additional insurance against these securities in the form of credit default swaps (CDS), again sacrificing profit for security.  There were a good many mistakes made by the banks during the past decade, as in the case of any business, and not all of the banks took the same level of risk, but blaming it all on those greedy bankers is too simplistic.

So what does all this matter to an investor?

As we analyze the markets, we keep in mind the impact regulations and subsidies can have on the economy and are incessantly skeptical when we see bubbles form so that we can both protect and take advantage of the distortions they create.


  • Acharya, Viral V., and Philipp Shnabl. 2009.  “How Banks Played the Leverage Game.” In Acharya and Richardson 2009b.
  • Bergsman, Steve.  2004. “Closing the Gap.” Mortgage Banking (February): 52-29
  • England, Robert Stowe.  2002.  “Giving it 100 Percent.” Mortgage Banking (February): 68-76.
  • Friedman, Jeffrey. 2009. “A Crisis of Politics, Not Economics:  Complexity, Ignorance, and Policy Failure.” Critical Review Volume 21: 127-183.
  • Schwartz, Anna J.  2009.  “Origins of the Financial Market Crisis of 2008.”  Cato Journal 29(1): 19-23.