We the Cared For: A Crisis in Capital for Free Market Capitalism

The two primary issues at hand for policy makers are to deal with the current crisis and to change the system moving forward to avoid repeating the problems.

In my ongoing efforts to come at this from different angles to explain why, even as the government(s) pump trillions of dollars into the system and nationalize everything, the stock market and the economy are still in for a very painful time.

The fundamental factors in all of these problems are that excess credit availability, fueled by government policy and private market greed, has over inflated the value of everything. During this period we did not put away enough money in the system (adequately reserving and capitalizing) for the increased risk (over leveraged).

In the 7 year period between 2001 and 2007, $19 trillion dollars in mortgage loans were originated. In the prior 10 year period, between 1990 and 2000, approximately $10 trillion in mortgage loans were originated. In the last 7 years we financed twice the amount of mortgages as we did in the previous decade.

During this same period private mortgage backed securitizations accelerated from virtually nothing to approximately $1 trillion dollars in 2006 and 2007…

And Fannie Mae and Freddie Mac doubled their retained and mortgage backed securities from over $2 trillion in 2001 to $4.9 trillion in 2007…

These mortgage backed securities were then leveraged up again as Wall Street firms created synthetic products from the underlying MBS, or collateralized debt obligations (CDO). This can be complicated so for simplification you can think of it as; the same collateral that made up one MBS was used to make another investment instrument… it was used twice. When the one loan or tranche goes bad, two different sets of investors lose their money.

On top of all of this is the additional leveraging up through the use of Credit Default Swaps (CDS) which are used for hedging purposes and significantly now, for speculation.

So what is the significance of this?

Prior to the advent of aggressive securitization by the GSEs (Fannie and Freddie), and the private Mortgage Backed Securities market, these loans had to be accounted for on lenders balance sheets. This required the banks to adequately capitalize themselves to support these balances and set aside cash reserves for the potential losses from these loans.

In the securitization model this doesn’t exist to a great extent because these loans are moved “off balance sheet” if they are treated as a “sale”. The accounting rules for these transactions are complex and contained primarily in FASB 140.

Derivatives; Credit Default Swaps (CDS)

To keep this simplified, a CDS is where one party makes insurance payments to another party (counterparties) to pay-off the credit extended in the case of default (non-payment, bankruptcy). If I am the premium paying party (Buyer) I will be paid off by the insurer (Seller) if the third party (Reference Entity) doesn’t pay off the loan, bond etc.

Basically banks and speculators are buying and selling credit insurance to each other for the performance of the bonds and companies. The problem is they are also speculating by trading in the CDS even if they don’t own or have an interest in the collateral.

The OCC’s Quarterly Report on Bank Trading and Derivatives Activities for Second Quarter puts this number at $15.5 trillion for U.S. Commercial banks. Credit Default Swaps are 99% of this number.

The bottom line is this; we completely refinanced existing mortgages that were “on balance sheet” and adequately capitalized and reserved for in the system, with new mortgages that were primarily put into private or public securitizations, many treated “off balance sheet” in the trillions of dollars. Then we created synthetic securities on top of those. Since the same loans are used as “collateral” or are the “underlying collateral” for the synthetics, when the loans go bad multiple investments go bad, and many more investors lose their shirts.

A Simplified Example

Let’s take an over-simplified example of one mortgage loan made $200,000. The person that loaned the money, sold the loan to an investor and took their fees. The investor is now responsible for the loss. This loan is again used to sell to another investor in a derivative Wall Street product, so now there is $400,000 invested in this same $200,000 loan.

Both of these investors are concerned that the loan may go bad so they buy a credit default swap.

Other speculators wanting to make money on this loan buy credit default swaps on the loan as well betting on one side it will pay and on the other it will default. Now let’s say there is over $1.5 million invested and bet on this one $200,000 loan and only one or two people reserved a little money to cover any loss… and it stops paying. We have a credit crisis and a crisis of capital.

The GSEs

Fannie Mae and Freddie Macs share of these mortgages may seem somewhat inconsequential on a percentage basis, in 1995 it was 35.7% and in 2007 it reached 41.4%, however in dollar terms it meant that Fannie and Freddie, meaning the U.S. tax payer (now obvious to everyone at this point) stood behind an additional $3.6 Trillion dollars in mortgage loans. As far back as December 2004 OFHEO, Fannies regulator, rated Fannie Mae as “significantly undercapitalized”.

The table below is a combination of FDIC Statistics on Institutions and the Federal Reserves statistical release“Flows and Outstandings Second Quarter 2008” .

Observable in this data is that from the period of December 2005 to December 2007, residential mortgage loans (1-4 and multi-family) outstanding increased in total (inside the FDIC Bank group plus outside the banking system) over $8 trillion dollars. The FDIC banks loss reserves which are the reserve for all loans including credit card, auto etc. went up a mere $42 billion during the same period.

What can also be observed here is that although Tier 1 Core Capital also went up in the system by $589 billion, when you add the mortgages outside the system together with the leveraged synthetic products plus inadequately capitalized GSE’s and investment banks, you have a significant gap in loss reserves and capital in the entire system. $8 trillion dollars in additional mortgage balances and multiples of risk in the derivatives market including CDO^2 and $15 trillion in Credit Default Swaps.

Where-oh-where is the capital to support this leveraged up risk?

It's in the U.S. Treasury.

The fees to each of the participants were large, the government was pushing hard for over 20 years to democratize credit, not enough capital is set aside capital for the risk and good loans are made and bad loans are made. House prices are pumped up, businesses are expanded, jobs are added, and up we go.

Since the fix to the moral and the future financial hazard is to force adequate capitalization for risk, the availability and velocity of credit will have to return to its pre-2000 levels… and down will come everything with it until the asset prices meet the investment and spending level represented by this responsibly adjusted amount of credit in the market.

The government is trying to stem the tide through massive infusions of tax payer dollars, but if we put the appropriate safeguards in the system moving forward, it will be an artificial floor with artificial values that will meet their maker some day when there isn’t enough taxpayer dollars to make up for the difference between rational, and irrational credit availability.

It’s really not a “new” reality. It’s the reality that was always there, we’ve just run our tax paying heads smack into it as we were blown out of Alice in Wonderlands rabbit hole.

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Posted by: TamikaFarley33 | July 07, 2011 at 05:43 AM