Securitization and Responsibility
By Jonathan
Wallace jw@bway.net
In his first movie, “The Strange Loves of
Martha Ivers”, Kirk Douglas says something like: “Its not your fault. Its not
my fault. Its nobody’s fault.”
Years later, I watched “Shoot-Out at the OK Corral” and heard Douglas, this
time playing Doc Holliday, say: "It’s not
your fault, Kate. It’s not my fault. It’s not anybody's fault. It’s just the
way the cards fall."
About
thirty years after he made that movie, at the tail end of his acting career,
Douglas appeared in a science fiction film called “Saturn 3” in which he
defends Farrah Fawcett-Majors from a mad robot rampaging on board a space
station. (The robot rips off the face of its handler, Harvey Keitel, and wears
it over its own blank metal countenance.) Apropos of the whole question of
technology going mad and destroying its creators—a classic 1970’s movie
trope—Douglas says wearily at the end of the film:
“Its
not your fault. Its not my fault. Its EVERYBODY’s fault. “
I
haven’t seen that movie since the year it came out, but I will never forget the
line.
(Note:
I was only able to verify the exact language of the “OK Corral” line.)
“Securitization” is defined as “a financial transaction in which assets are
pooled and securities representing interests in the pool are issued.” www.riskglossary.com
The creation of a loan- or credit-backed security (such as the
notorious mortgage backed securities which have put us all into the current
soup) serves several purposes. On an accounting basis, the assignment of the
loan to the pool gets it off of the lender’s current books. Secondly, it brings
in cash—from the purchasers of the security—which can be used to write more
loans.
Sounds very healthy and growth
oriented, doesn’t it? In reality, during the recent real estate bubble,
billions of dollars worth of bad and doubtful mortgages were packaged into equally dubious
securities. As these have become worthless or near, they have brought down august
institutions such as Lehman Brothers and Citibank, leading to a domino effect
which is effectively tanking the stock market, employment, retail and other
things we need and care about.
When you take a close look, the
ethics of securitization are quite interesting.
Fucking with
the risk-reward ratio
One of the truisms of finance,
marketplaces and “invisible hand” theology is that the greater the risk, the
greater the reward. At the individual level, we are all familiar with this via
any position we have in stocks or mutual funds. In the present environment, my
401(k) has fallen further than the rest of my holdings. The explanation: Its
invested for more growth, less conservatively, because it exists to take care
of me twenty years from now, not provide income today. Therefore, I agreed to place
it in riskier funds, a gamble paying off badly today.
However, the big guys regard the
risk-reward ratio as a mere starting point for analyses dedicated to finding
new ways to avoid, defer or spread risks while maximizing returns.
In a bull market, this sounds like a
Good Thing. My first encounter with the concept of spreading financial risk
came with some reading I did on maritime law as a young lawyer in the 1980’s. I
was fascinated by the idea of risk pools, re-insurance, companies which could afford
to insure more ships because they were able to turn around and lay off part of
the risk on other companies.
Sharing the risk with other
knowledgeable entities seems like it fosters the development of trade and
commerce. In eighteenth century terms, more ships are busily sailing to more
ports with more goods on board. From a moral standpoint, international
seafaring trade in goods (other than slaves or opium) seems like a benign,
pacific thing: tying very unlike peoples together in a peaceful relationship
based on the goods they exchange; promoting some knowledge of and interest in
the foreign spurred by exotic things (foreign spices, edibles, manufactured
goods).
A similar contemporary argument for
the benefit conferred by mortgage backed securities: they make more money
available to loan to people who might not otherwise be able to buy a house.
Sharing the risk means retaining
some. The whole system crashes when the risk becomes so diffuse that it
effectively has been divorced from the reward.
The securitization of mortgages was from this perspective a great idea
for the people who could take the money and run, and a damn bad one for
everyone else. It meant that some could profit without facing any consequences,
while others—the last purchasers of the securities, the homeowners and finally,
the rest of us as taxpayers—take the full brunt of failure.
Take the money
and run
I have written elsewhere about the
experience of being involved with one of the last (and least) companies to go
public in the Internet bubble. We, the executive management and owners of the
company, were fooled into thinking that the company could sustain itself as a
public entity. Today, with twenty-twenty hindsight, I don’t believe the
investment bankers really believed their own hype.
What I learned about IPO’s is that
on the day of the stock issue, there
are four basic types of players, the Issuer, the Investment Bank representing
it in the IPO, the Institutional Investors, and the Idiots (small stock market investors with a dollar
and a dream).
The Issuer sells all the shares of
the initial public offering to the Investment Bank at, say, six dollars a
share. The Investment Bank flips the
shares to its preferred list of Institutional Investors at nine dollars. The
Institutions flip the stock the same day to the Idiots for twelve dollars or
whatever the market will bear. The Idiots are paying full retail price in the
mute hope that the stock will be bought from them in days and weeks to come by
people more clueless still, at a mark up over full retail.
Given that the Investment Bank is
not required by law to maintain a continuing large position in the stock (not
if it has correctly created the market and can flip everything), what is the
bankers’ incentive not to commit fraud: lie to
the Idiots about the value of the stock, leaving them holding the bag
while the Investment Bank and the Institutional Investors walk away smiling?
There are four answers to that
question: the Invisible Hand; conscience; reputation and the fear of
regulators.
Invisible Hand theology says that no
businessman will ever commit fraud, because no rational thinker would settle
for a one time profit in lieu of maximizing his profits for years to come. The
reputation argument is quite similar: if an Investment Bank becomes associated
with shoddy IPO’s, it will have problems finding Issuers in the future, or
selling the stock of the Issuers it does find to the Institutions.
In reality, these considerations
become inconsequential if the one time profit is large enough (how many boats
can you ski behind?) or the bankers are
not planning to be around to incur reputational damage. The 135-year-old
independent institution which took my company public at the end of the Internet
bubble, merged with a commercial bank within the year.
Conscience is a wash: some people
have it, some don’t, and the diffusion of responsibility which is the modern
corporation tends to ensure that the conscience of the corporation itself is no greater than the lowest common
denominator.
The fear of regulators substantially
went away during the Reagan, Bush, Clinton and Bush 2 administrations, when
people like Senator Phil Gramm and former Fed chairman Alan Greenspan made sure
that the securitization of sub-prime mortgages could go great guns unsupervised
by any grown-ups. An old business joke of endless variations, and always a good
one: “What is the difference between (fill in the blank) and a boy scout
troop?....A boy scout troop has adult supervision.”
So essentially Investment Bankers
had no compelling reason in the ‘90’s and the early years of this century not
to commit fraud.
Who are the
villains?
There are two types of culprits, those
who got away with riches and those who believed their own hype and got tagged.
I can’t prove the former exist, but assume there are people so expert at the
timing that they made millions and got out while they could. Among these would
be mortgage brokers, who sold but did not actually take any risk on subprime
mortgages, who banked their commissions and moved on to the next big thing
before the crash.
There seem to be a surprisingly
large group of traditional Investment Banks, like Lehman Brothers, who invested
too substantially in mortgage backed securities themselves and got hit and
badly hurt when the bubble collapsed. While con artists who steal large sums
and leave are a familiar archetype, the self-deluded wizard who stakes his life
on magic only to discover it doesn’t exist, is harder to understand.
Believing the
hype
Why would anyone as putatively
intelligent as the CEO’s of Lehman Brothers or Citibank allow their
institutions to take a huge position in anything as airy and insubstantial as
mortgage backed securities?
A meme repeated by numerous
columnists in recent months is that of the indulgent CEO who complacently
allows the young hotshots to create and experiment with financial instruments
he doesn’t understand. Sort of like allowing the youngsters to experiment with
nitroglycerin in the basement.
Another possible factor derives from
our uncritical worship of technology. This was a familiar phenomenon from the
‘80’s on, when so often a hotly heralded new software application turned out to
be a badly done human effort with glitzy tech attached (a faulty algorithm viewed
through some really fancy graphics and windows). A classic example was
filtering software, which promised to protect us from Really Nasty Stuff on the
Internet, and which turned out without exception to have at its core either
blacklists hastily compiled by tired, low-paid humans or automatically compiled
by “bots” using really primitive search terms (some early programs wouldn’t
allow you to access chicken breast recipes, or read scholarly articles on Web
sites like the Spectacle about the
ethical implications of pornography).
Investment vehicles, especially the
complicated ones, are a form of technology, at least metaphorically speaking.
In common parlance, they are “engineered” and the people creating them are
technical wizards with PhD’s in quantitative analysis.
A third explanation is the denial
produced by complacency and fueled by greed. If something is making crazy money
today, we want to believe it will continue to do so tomorrow. This seems to me
a by-product of the same intellectual laziness which leads us to believe that
we live in the best of all possible worlds, to love kitsch, swear unquestioning
allegiance to the flag or shout loudly that the emperor does in fact have
clothes. I submit in minor support of this proposition that since time
immemorial, all Investment Banks have employed research analysts to cover the
various industries in which the bank promotes IPO’s, and that never once in all
that time has any analyst ever recommended the sale of a single stock, no
matter how badly its doing. This is not an exaggeration. One of the
peculiarities I learned about first hand when we were doing our IPO, and for
some years read much of this research, was that the recommendations were
calibrated to various levels of Buy, Hold, Hold With Caution, whatever….but
never once was there a report which said “Sell This Piece of Shit”.
Investment Banking in a bull market
was a consensual hallucination which never had much logic behind it.
I would love to know how many people
at Lehman Brothers thought that mortgage backed securities were good paper and
how many knew they were shit but believed the prices would stay good a day
longer than they did.
George Bailey’s
World, and Ours
The chattering class has recently made
frequent reference to the bank run scene in the kitschy but effective “It’s a
Wonderful Life” where James Stewart’s character, George Bailey, stops a bank
run with the following rhetoric:
[Y]ou're thinking of this place all
wrong. As if I had the money back in a safe. The, the money's not here. Well,
your money's in Joe's house...that's right next to yours. And in the Kennedy
House, and Mrs. Macklin's house, and, and a hundred others. Why, you're lending
them the money to build, and then, they're going to pay it back to you as best
they can. Now what are you going to do? Foreclose on them?
The movie was undoubtedly overly
simplistic at the time it was made, but it makes me deeply nostalgic for a
smaller world I have never really known. There is a lot to be said for a
culture in which if some of your receivables didn’t come in this month, you can
see George at the bank and tell him you will be a little late with the
mortgage.
In the world of securitization,
there is no George. One of the most remarkable aspects of the present crisis
has been the discovery that it is
difficult or impossible, where securitized mortgages are concerned, to identify
any individual who has the authority to negotiate the terms. It even appears
that some individual mortgages may have been “sliced and diced” so that parts
are somehow included in the pools backing different securities.
Some issuers have stated their opposition
to any public policy mandating or encouraging renegotiation on the grounds that
changing the terms of a defaulted mortgage harms the security of which it is a
part (which one would think was already worthless or nearly).
I can think of no better reason why
mortgages should never be securitized again.
A Castle Built
on Shit
Part of the problem with securitization
is derived from an inherent problem shared by all security marketplaces in the
first place. A quote I encountered today while looking up terms on the Web was
to the effect that a share of stock is part ownership of a business, and not a
lottery ticket.
What tends to happen in the absence
of realistic regulation is that the security becomes more important than the
business it represents.
I first encountered a related
phenomenon when as a young lawyer in the 1980’s, I represented a tax shelter
promoter. One of the shelters he offered was based on a software company. When
I offered to audit the contracts and intellectual property of the company to
look for ways to improve its standing and protections, the client looked at me
as if I were crazy. The company didn’t have to be solid or have great
prospects. It needed merely to exist, however shoddily or nominally, to form
the basis of the shelter.
The Investment Bank which took my
company public ten years later had the same attitude about us.
I think the world of high finance
(like other features of our cultural life which represent the
imaginary-become-real) has a lot in common with the world represented in Philip
K. Dick’s “Time Out of Joint”, in which objects like a drink stand in the park
occasionally would fade away, leaving a piece of paper with the word “drink
stand” written on it. In the case of the tax shelter and the IPO both, there
just needed to be a slip of paper nearby bearing the words “software company”.
Why would anyone cooperate who knows, or should know, that the product
on which the whole structure is based,
is not real?
The diffusion of responsibility and
conscience in corporate America ensures that people with nagging doubts about
the underpinnings of the product rarely resign. That same complacency referred
to above ensures that most of us will trust that our managers, or the CEO,
understands something we don’t; the love of technology reassures us that shit,
in a really great wrapper, is no longer shit, or that no-one will notice it is
until the end of time.
Subprime mortgages were shit. As
everyone knows today, people ineligible for credit under any normal definition
were given adjustable rate mortgages they didn’t understand, in many cases with
balloon payments which were not explained and which they predictably would
never be able to make.
This is a classic con, for which
people should have been sent to prison. It wasn’t about giving indigent people
a chance at home ownership. It was about conning them out of their money, about fucking with the people least able to
protect themselves.
If you want to get money into the
ghetto and promote home ownership, imitate some successful public programs
which made cheap fixed rate loans available and extended them to hard working
poor people most likely to be able to make the payments.
Some homeowners have been raped twice, once by the broker who sold
them the subprime mortgage, then a second time when it was securitized.
High level
fighter cover
Alan Greenspan on securitization, at a Fed conference in 2005:
Innovation has brought about a multitude of new products, such as
subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have
driven the financial services industry throughout the history of our country…The mortgage-backed security helped create a
national and even an international market for mortgages, and market support for
a wider variety of home mortgage loan products became commonplace.
http://www.globalresearch.ca/index.php?context=va&aid=8032
And Phil Gramm, at a banker’s
conference circa 2001, as quoted in a recent New York Times article:
Mr. Gramm said the problem of predatory loans was not of the banks’
making. Instead, he faulted “predatory borrowers.” The American Banker, a trade
publication, later reported that he was greeted “like a conquering hero.”
http://www.nytimes.com/2008/11/17/business/economy/17gramm.html?pagewanted=1&_r=2&sq=predatory%20borrowers&st=nyt&scp=1
Again, just to be clear what we are
talking about. A broker who understood the terms of what he was selling sat
down with a prospect who did not and, with a straight face, sold him an
adjustable rate mortgage with a monthly payment of $800. In some cases, this was an artificially low “teaser” rate, good only for a few months. Eventually, a year
or two down the road, the mortgage reset, the monthly payments became $1800 and
unaffordable, and the borrower wound up in foreclosure.
In the local newspaper in Lee
County, Florida, there is a columnist named Mel Payne who specializes, with
compassion and indignation, in trying to right wrongs done to local consumers.
One of her columns involved the case of the elderly man who paid $1800 for a
vacuum cleaner he didn’t need and could not learn to use. Mel spoke eloquently of the soul of the
salesperson who would close such a sale. If these kinds of stories shock our
conscience, so should the stories of adjustable rate mortgages sold to people
who would never be able to sustain the payments. There is no moral difference even though the transaction is
ultimately backed or legitimated by Citibank instead of being the sole
responsibility of Joe Asshole the vacuum cleaner salesman.
Bob Herbert of the New York Times is
the last old fashioned, big hearted liberal writing for that paper (he may be
the last one in America). In a recent column on President-elect Obama’s
proposed push to rebuild the decaying infrastructure of our country, Herbert
asked why every administration of the last few decades has attempted nothing to
solve this problem. His answer: because our leadership, not just the current
administration, has thrived for years as a culture of pillage and plunder, not
of repair and sustenance.
Why isn’t
everyone angry?
People are starving in third world
countries, or dying of untreated disease, directly
as a result of a bunch of hyperactive, narcissistic whiz kids flacking
subprime mortgages in the United States. Every day we read in the paper of
retirees losing their savings, banks failing, and job losses in Europe and
Asia, as the emergency we created spreads world-wide. Of course there is blame
for the bankers elsewhere who invested depositor’s money in shit instruments
issued in the US (or emulated them with locally issued toilet paper).
There seems to be a minimum of
focused rage aimed at the United States, which is puzzling.
It may be that a big enough
catastrophe always feels like an act of God, drowning our anger at the people
who brought it on. I felt this way after September 11. For a long time the
daily problem was getting by and helping other people in a city where Ground
Zero was still on fire.
Perhaps some people elsewhere think
that the U.S., which has so often buoyed or rescued First World countries both
economically and militarily, has a right to sink them every once in a while?
I think ultimately the adroit
diffusion of risk and responsibility represented by the securitization of
subprime mortgages fools many into treating a crisis born of human greed as an
act of God.
Which leads us back to Kirk Douglas’
fatalistic statement at the end of “Saturn 3”: Its EVERYBODY’s fault.
But we can and should still place
most blame on the people with the power and the authority to prevent it, who were too busy making
profits or protecting their friends at the crucial moment. People like
Greenspan and Gramm.