January 2009

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.


           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.”


           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.