Between the years of 1998-2002, numbers in baseball reached and surpassed historical levels. The incredible boom in the power and longevity of players raised suspicions of doping and cheating and finally prompted a comprehensive and independent investigation. The increase in homeruns during this period was so swift and large that something sinister had to be going on.

The same can now be said for the mortgage lending practices that plagued our economy for the first half of this decade. Interest rates hit basement levels as housing prices skyrocketed between 2002-2005. During this housing bull, mortgage lenders began to realize that they could be cashing in on a large piece of the housing pie. Adjustable rate mortgages were being passed around like “B-12” shots in a locker room. But the lenders were not hiding in the shadows. This was going on right in front of us. Just as we saw marginal players begin to sock 50 homeruns in a season, so too have we seen single mortgage brokers pocket as much as $750,000 in a single year by relaxing their lending practices and preying on uneducated borrowers.

In baseball, we have seen a great deal of blame for this mess being passed around, and for good reason. Players who knowingly took performance-enhancing drugs to boost their production deserve to be punished. Teams who allowed their players to participate in this form of cheating deserved to be scorned. The commissioner of baseball who allowed this problem to persist under his watch deserves to be criticized. And fans who shielded their eyes from the truth that was painfully obvious for so many years deserve what they got.

The parallels between the actors in both these scandals are many. Too many mortgage brokers took advantage of loose lending practices with their eyes on fat bonuses and inflated commissions. The CEOs of big lending houses allowed this to go on as they collected their huge salaries. Borrowers too blinded by the ease and availability of cheap money took what they could get and entered into agreements that they simply could not afford. And the chairman of the Federal Reserve sat idly by as the bubble grew so large that it could no longer be contained.

Baseball has finally done the right thing. By hiring Sen. Mitchell, Commissioner Bud Selig has now shown the public that not only is he aware of a problem, but he is also interested in a solution. He has allowed the names of some of his most revered and marketable stars to be printed in a laundry list of cheaters for everyone to see. He has shown a willingness to single out the perpetrators and has even assigned a share of blame to himself. We have the names — all 85 of them — and now we know who’s done us wrong.

So who are we going to blame for the subprime mortgages?

President Bush has decided to step in and offer a plan to help those who have been hurt by this fiasco. He is offering relief to borrowers who find themselves threatened by resetting interest rates. Many homeowners signed on with cheap adjustable-rate mortgages that will soon be much more expensive than they had been. The reason this subprime lending has become such a mess is that while rates are increasing for these borrowers, the prices of their houses are falling.

The president has proposed a freeze on rate increases in order to protect borrowers who are unable to manage the coming reset. What this move does is bail out any low-credit individual who made the faulty decision to purchase a house out of their price range. Unfortunately, this is not new legislation, nor is it a government mandate. The president is merely suggesting that, for the good of the economy, lenders help out the poor souls who will soon be unable to afford their dream house.

This is quite similar to how Commissioner Selig originally handled the steroids crisis in baseball. While steroids have been considered illegal in the game since the 1970s, baseball had never specifically tested for their use until 2002. Players were told not to take them, but neither the league nor the teams ever actively investigated their use or punished any offenders. The players were left to police themselves, and the situation quickly got out of hand.

Baseball has now learned the error in its apathy. Congress has hinted at taking steps toward fixing the situation, but that seems to be out of its jurisdiction. Baseball recognized what it had to do and decided to take action. Major League Baseball paid the $20 million tab for this investigation and is now living with the results. Marquee players, including Roger Clemens and Miguel Tejada, have had their names and reputations sullied. Fans can now have improved confidence that the epidemic of cheating should largely be over. When will we be able to say the same thing about mortgage lending?

As long as mortgage company CEOs continue to take their million-dollar golden parachutes on the way down, the problem of shady lending practices may persist indefinitely. The president can urge freezes to help people who are suffering now, but someone is going to have to pick up the tab for all the unpaid debt. Perhaps we should follow baseball’s lead and begin to publicly out those who have done their customers and our economy wrong. Perhaps we need a list of names to show everyone exactly who is at fault.

History will remember the “steroids era,” just as it will the subprime housing crisis of 2007. Baseball appears to have learned from its own mistakes. Only time will tell if mortgage brokers can change their ways and avoid repeating the irresponsible behavior that has gotten them into this. Just like fans, borrowers will now have to be cynical and incredulous going forward. Whether it’s homeruns or houses, ‘roids or rates, if something seems too good to be true, it probably is.

Until next time,
Jamie Ellis

December 21, 2007

Setting the Records Straight was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

If a bank were to invest its capital 6% in mortgages on an “unlevered” basis, its return on equity would be 6% — the same return you’d get if you invested your equity, or savings, in a Treasury bond yielding 6%.

But banks invest shareholder capital in a way that multiplies returns and risk by 10- or 15-fold. A bank can multiply the size of its balance sheet when it borrows money from depositors. Banks shareholders use depositors’ money to buy new assets, which generate the cash that pays depositors back a fixed return. Then, these shareholders keep any returns over and above the returns paid to depositors. Shareholders face more risk, but can enjoy big returns if management invests bank assets in a wise manner.

Remember this formula when you hear the endless stream of news about write-offs, SIVs, CDOs and asset-backed commercial paper. To understand what’s going on, just plug these exotic instruments into the asset and liability accounts of banks like Citigroup.

Among bank assets, mortgage-backed securities now play as big a role as plain vanilla mortgages. Among bank liabilities, commercial paper and derivatives have grown in importance relative to old-fashioned deposits. This creates the potential for bank equity, or capital, to vanish when assets turn out to be unexpectedly risky, or even worthless. 

An article in The Economist explains:

“All this turmoil is focusing attention on banks’ capital ratios, the amount of money they set aside as a percentage of assets to cover unexpected losses. This cushion is being squashed in a number of ways. First, net losses eat directly into capital. Second, since capital ratios are typically calculated on the basis of how risky a bank’s balance sheet is, the ratings downgrades add to the amount of rainy-day money banks need to set aside. Third, assets are growing as banks take on the financing of more off-balance sheet vehicles, which again adds to the capital they need.”

Banks and other financial companies that find themselves on the wrong side of this financial crisis must rebuild capital. There are a number of ways they can accomplish this, but all are unpleasant.

First, the company could issue new shares. This hurts because it dilutes existing shareholders when stocks prices are already depressed. It’s especially embarrassing for companies like MGIC Investment Corp. and MBIA, Inc. These insurers were buying back gobs of stock at much higher prices. Now they’ll probably have to sell this stock back to the market at low prices, resulting in hundreds of millions in economic losses for shareholders. This is a painful move for these companies, but they must cover their liabilities, which include paying for the impending wave of insured losses in structured credit and mortgages.

Second, the companies could cut dividends. When a bank pays a dividend, this transaction reduces both assets and equity, resulting in a slightly diminished ratio of equity to assets. When this ratio falls below a certain level, a bank can count on receiving more regulatory scrutiny. Cutting the dividend may be painful for shareholders, but it’s often the least painful way to rebuild capital.

Third, the companies could sell “noncore” assets. Financial conglomerates like Merrill Lynch have the option of selling their interests in a wide range of businesses to raise cash. Merrill owns almost half of publicly traded money manager BlackRock. Merrill could sell this interest in order to rebuild capital in its division that’s getting pounded by CDO losses.

Finally, this hypothetical financial company could slow the growth of its loan portfolio. This would allow the cash that normally flows in from older loans to remain on the balance sheet, instead of funding new loans. On a company level, this may be a good thing, but on an economy-wide level, it’s not. When banks slow down lending, it makes credit harder to get — even for those with good credit.

Citing Goldman Sachs estimates, The Economist article notes, “If banks suffer a $200 billion loss on subprime mortgages but want to keep their capital ratios at an average level of 10%, that would stifle lending by a whopping $2 trillion.”

Government-sponsored entity Freddie Mac spooked the markets last week when it announced it must raise capital amid rising losses. This will involve some combination of the unpleasant choices listed above. It’s not good news for housing market finance because it means Freddie will be less aggressive in buying mortgages from banks — at a time when Congress has been pushing to allow Freddie to become more aggressive.

Washington, D.C., politicians are in the process of concocting some type of tax- and inflation-financed housing bailout, but it could take longer than expected. Financial stocks are oversold, and may be due for a bounce, but they are not out of the woods yet.

Regards,
Dan Amoss, CFA

December 17, 2007

We Can Rebuild It was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.