Let's go back to the financial crisis and the practices that brought this country to its knees. Banks developed a fancy scheme whereby they absolved themselves of all risk from the loans they made. They simply wrapped them up in a bundle and sold them to someone else. What they were doing is essentially packaging and reselling "junk."

When the news of how bad things were became known, the markets froze and collapsed. No one knew who had which securities, and if they did, they didn't know their true value.

Continue reading Banks Lobby Against Risk Retention on the Loans They Make

Banks Lobby Against Risk Retention on the Loans They Make originally appeared on BloggingStocks on Sat, 02 Apr 2011 11:40:00 EST. Please see our terms for use of feeds.

Continue reading What to Do About the Collapsed Debt Market?

What to Do About the Collapsed Debt Market? originally appeared on BloggingStocks on Thu, 01 Jul 2010 16:00:00 EST. Please see our terms for use of feeds.

Continue reading Pensions Consider Insurance Securitization Finance Because You Refuse to Die

Pensions Consider Insurance Securitization Finance Because You Refuse to Die originally appeared on BloggingStocks on Mon, 15 Feb 2010 14:40:00 EST. Please see our terms for use of feeds.

Tonight I am appearing on a Boston TV program to discuss whether there are other Madoff disasters lurking as well as eight lessons from 2008. The first half of the program will feature Congressman Barney Frank (D-MA) who chairs the House Financial Services Committee.

The TV producer suggested that I should give Congressman Frank some thoughts about how to fix the financial services industry if I get a chance to talk with him in the green room before the show starts. I am not sure whether I will get to do this or not; however, here are four ideas I will share if I get the chance:

• Limit leverage. Starting with an SEC ruling in 2004, banks could borrow as much as they wanted -- in some cases over $30 for every $1 of equity. This borrowing has endangered the global financial system. Washington should limit leverage to 8:1 or less.
• Put banker pay in escrow. As I posted, banks should not pay bankers to close big deals and then let them keep the bonuses after the deals fall apart. Instead, they should do what Morgan Stanley (NYSE: MS) is starting to do, which is to put the bonuses in an escrow account -- if the deals lose money in the years following the contract signing, the money goes to pay off the investors. Otherwise, they get to keep the money.

Continue reading Memo to Barney Frank: Four steps to fix finance

Memo to Barney Frank: Four steps to fix finance originally appeared on BloggingStocks on Mon, 29 Dec 2008 17:30:00 EST. Please see our terms for use of feeds.

It looks like America has shut down until 2009. And that's probably a good idea because there were so many bad ones in 2008. Bad ideas are like vampires. They charm their way into the good graces of a host society and then they suck the blood right out of them.

Although they all didn't just pop into our lives in 2008, these eight ideas reached a peak of awfulness in 2008:

• Deregulation is good. The wave of deregulation that started in the early 1980s has created enormous problems for society. Sure there were some bad regulations on the books, but just one deregulated industry -- the $62 trillion credit default swaps (CDS) market -- has cost taxpayers hundreds of billions of dollars in the bailout of American International Group (NYSE: AIG).
• If you can lend against it, securitize it. Securitization -- the practice of buying, credit-rating, and bundling loans backed by assets like mortgages, credit card receivables, and leveraged buyout loans -- created the illusion that you could mix risky loans in with safer ones and you could earn above-average returns with no risk. Bad call -- securitization has spread toxic waste around the world from Iceland to Whitefish Bay, Wis.
• Home-ownership is good for everyone. The hungry maw of securitization created enormous demand for new mortgages. And that led mortgage originators to lend to people who couldn't afford to pay back the loans. The $1.3 trillion subprime mortgage market was born and it grew so big that its collapse refused to remain contained. In 2004 Bush bragged about home ownership reaching 69.2% -- three million foreclosures later it seems we should be careful what we wish for.
• Leverage up your balance sheet 30:1 or more. In 2004, the SEC gave financial institutions (FIs) discretion to borrow more money than they had ever borrowed before. Most banks and hedge funds borrowed as much as $35 for every $1 of equity. If they had used their $340 billion in equity to buy the $13 trillion worth of mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs), a 3% decline in the MBSs and CDOs value would have wiped out the FI's capital.

Continue reading 2008's eight worst ideas

2008's eight worst ideas originally appeared on BloggingStocks on Sat, 27 Dec 2008 16:45:00 EST. Please see our terms for use of feeds.

There has been much fear mongering in Washington over the last year as the financial crisis has built to a boil. But despite the most recent efforts to scare Congress and the American people into action, there has been very little light shed on some basic questions.

And I believe that before another penny of American taxpayers money is spent, our leaders need to spend more time explaining what is going on and why change is required. What we are facing is a crisis of confidence -- we are witnessing the erosion of trust in our leaders and our financial system.

People no longer believe our leaders have our best interests at heart. In the wake of the Auction Rate Securities scandal, people doubt the basic fairness of our system. People do not know the details of their accounts -- for instance few people have read the prospectus of their money market funds. And there is a lack of powerful ideas to sustain people's belief in the system.

Continue reading 100 Year Crash: How did we get here? What should we do now? What about the future?

100 Year Crash: How did we get here? What should we do now? What about the future? originally appeared on BloggingStocks on Sun, 28 Sep 2008 22:19:00 EST. Please see our terms for use of feeds.

It seems that there is a problem with our financial system. That could be why Bear Stearns collapsed, the government took over Fannie Mae (NYSE: FNM), Freddie Mac (NYSE: FRE) and American International Group (NYSE: AIG). This problem could also explain why Merrill Lynch sold out to Bank of America (NYSE: BAC), why Lehman Brothers went bankrupt, and why JPMorgan Chase (NYSE: JPM) bought Washington Mutual (NYSE: WM). Problems with our financial system could also explain why the Commercial Paper market is freezing up -- making it harder for companies to come up with the short-term cash to pay employees and buy inventory.

But how did our system get to this point? There are five key principles of our current financial architecture that brought us here:

• Securitization. Up until about 30 years ago, people took out mortgages from an S&L and paid their loan officer every month until they owned their house. In the 1980s, Wall Street invented securitization -- the process of buying up, say, 1,000 mortgages from mortgage companies, creating a security based on those mortgages, paying for a AAA rating, and selling the securities to investors worldwide. Securitization is a problem for reasons I'll describe below.
• Too much borrowing. Over the last several years, Financial Institutions (FI) have made some $2 trillion in fees from securitization, according to DealBreaker. One reason for this is that they have been able to buy these securities -- of which there are $13 trillion on the market between Mortgage-Backed Securities (MBSs) and Collateralized Debt Obligations (CDOs) -- with a sliver of capital, roughly $340 billion. The typical FI had a ratio of assets to capital of 30:1. This meant that a mere 3% decline in the value of these securities would wipe out all the capital.

Continue reading 100 Year Crash: How did our system get to this point?

100 Year Crash: How did our system get to this point? originally appeared on BloggingStocks on Sat, 27 Sep 2008 22:16:00 EST. Please see our terms for use of feeds.

I have been astonished by the speed of the collapse of our financial system. There is no precedent in my lifetime for such a rapid collapse. And I doubt that the lessons of the Great Depression pertain to the current situation. This is the Greatest Depression -- about which I posted in March -- and the lessons of this one are likely to expose five fundamental flaws in our financial architecture.

These flaws are the reason for the rapid meltdown and they include:

1. Securitization -- the popularity of shifting risk from an originator to a group of investors in a package wrapped in a AAA credit rating based on flawed analysis.
2. Lack of transparency -- the inability to estimate the future cash flows of such a complex security -- thereby creating massive uncertainty in a period of decline.
3. Leverage -- borrowing way too much money with too tiny a sliver of capital to protect against risk -- making it possible to wipe out all the capital with a 6% decline in the value of these securities.
4. Heads-I-win, tails-you-lose pay -- Paying deal makers for the size of their deals and sticking taxpayers and shareholders with the losses.
5. Global interconnectedness -- thanks to information technology and ease of investment rules, a sneeze in the US causes hurricanes around the world.

How could we cure these problems? As I posted, we could end securitization, demand complete transparency, raise capital requirements, link pay to profits rather than sales, and create firewalls to prevent problems in one market from infecting the rest. But with the global financial architecture crumbling worldwide, there's no time for this now.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.

Why such a rapid meltdown? originally appeared on BloggingStocks on Tue, 16 Sep 2008 10:13:00 EST. Please see our terms for use of feeds.

It's been over a year since I last posted on liar loans -- these are mortgages which the borrower obtains despite offering no documentation on their income, employment or assets. These liar loans were also known as Ninja loans -- which is short for no income, no job, and no assets. The Associated Press reports that such liar loans will add $100 billion to the losses our economy is already suffering thanks to $400 billion worth of losses from subprime mortgages.

The problem we face as an economy is that it's hard to see where the liar loans end and the collateralized debt obligations (CDOs) and other asset-backed securities begin. In a sense, they are all liar loans. In the case of the mortgages, borrowers created paperwork that was inconsistent with their actual financial condition so they could get the money. In the case of CDOs, the issuing investment bank bought a AAA rating from a rating agency which created the illusion that the security was safe. Conceptually, there is little difference -- both depended on essentially forged paperwork to make the loan go through.

Why did banks issue liar loans? They were afraid to lose market share. But that doesn't make it right. As my mother used to say to me, if the other kids jumped off the Empire State Building, would you do it too? AP brings this to life in an interview with David Zugheri, co-founder of Texas-based lender First Houston Mortgage who said, "Everybody drank the Kool-Aid. They knew if they didn't give the borrower the loan they wanted, the borrower could go down the street and get that loan somewhere else.''

Continue reading Liar loans to add $100 billion in losses to subprime's $400 billion

Liar loans to add $100 billion in losses to subprime's $400 billion originally appeared on BloggingStocks on Mon, 18 Aug 2008 20:18:00 EST. Please see our terms for use of feeds.

Does America really need an economy that depends on creating new bubbles to get us out of the mess caused by the bursting of old ones? Is it possible to replace this with an economic system that generates growth without bubbles? I think the answers to these questions are No and Yes.

The most recent example of this bubble economy is the way the dot-com frenzy's aftermath was replaced by a debt bubble, which was focused heavily on a now-imploding mortgage-backed securities (MBS) industry. The dot-com bubble expanded thanks to the public's insatiable appetite for dot-com IPOs, regardless of whether the issuer was or could become profitable. The MBS bubble grew thanks to rock-bottom interest rates, rising housing prices and institutional investor demand for higher "risk-free" yields, all of which ignored the cost of a market reversal.

But the MBS part of the current bubble may not be the last to burst. There are also the leveraged loans that fueled a boom in private equity -- a market which has lost 70% of its business in the last year. Thankfully, massive defaults in such loans have yet to occur. The New York Times reports that capital-starved banks are starting to limit commercial and industrial loans that fuel normal business expansion. It reports that such loans have dropped 3% since 2007, from $3.36 trillion to $3.27 trillion.

Continue reading Creating a post-bubble economy

Creating a post-bubble economy originally appeared on BloggingStocks on Mon, 28 Jul 2008 11:30:00 EST. Please see our terms for use of feeds.

Bloomberg News reports that hedge fund Bridgewater Associates has estimated that the total write-downs from the current credit crisis will total $1.6 trillion. With $400 billion in write-downs taken so far, this $1.6 trillion estimate would put us about a quarter of the way through the crisis. So far, banks have raised $321 billion in capital to buffer those write-downs.

And Teddy Forstmann, a private equity veteran, agrees with this assessment. In an interview from Saturday's Wall Street Journal, he said the current credit crisis is the worst he's seen. As he said, the problem started after 9/11 with the Fed giving away money at negative real interest rates. This created so much cash that banks could not find ways to lend it out where risk and reward were in balance.

So they created new ones which mis-priced risk. These include loan syndication -- in which banks originate loans and take a fee for selling them to someone else -- and securitization -- in which banks packages lots of loans as securities and sell those to hedge funds and other institutional investors. Unfortunately, these only work when the prices of the underlying assets are going up.

Continue reading Banking crisis in second inning

Banking crisis in second inning originally appeared on BloggingStocks on Mon, 07 Jul 2008 12:12:00 EST. Please see our terms for use of feeds.

If an enemy sworn to the destruction of the global economy was given free reign, it would follow the strategies of its current leaders.

One key to destroying an economy is to break its pricing mechanism. What does an effectively functioning pricing system do? It creates a market of buyers and sellers who can meet, agree on a price, conduct the transaction, and create an information trail that permits future market participants to judge what might be a fair price for their transactions.

Another key to destroying an economy is to put too low a price on risky behavior. Why is it important to price risk accurately? Because if decision-makers do not assess the risk at the time of their decision, the economy will end up paying for the under-priced risk long after those decision-makers have left office.

So how have current leaders broken the pricing mechanism and under-priced risk? Here are three ways:

Continue reading What wrecked the global economy

What wrecked the global economy originally appeared on BloggingStocks on Tue, 01 Jul 2008 08:45:00 EST. Please see our terms for use of feeds.

DealBook reports that junk bond king Mike Milken is trying to defend securitization. Despite pleading guilty to six felony counts of securities fraud and conspiracy, paying $600 million in fines and spending 22 months behind bars, Milken is still quite highly regarded. But the defense he offers of securitization is pretty thin gruel.

Milken and I both studied under the same professor at Wharton -- making me feel a bit like Forrest Gump. After he taught Milken, the management professor told me that he concluded Milken would either make enormous amounts of money or land in jail. The professor's prediction proved correct -- except that Milken did both.

Milken's defense appears to be that securitization and surgery are alike. DealBook quotes Milken as saying that criticizing securitization - the slicing and dicing of debt that he helped popularize - is "like condemning scalpels because a few unqualified surgeons have injured patients."

Continue reading Milken's weak defense of securitization

Milken's weak defense of securitization originally appeared on BloggingStocks on Tue, 29 Apr 2008 12:02:00 EST. Please see our terms for use of feeds.

Reuters reports that First Marblehead Corporation (NYSE: FMD) -- a student loan securitizer -- is in deep yogurt and the stock market is not happy, knocking 42% out of its stock. The reason? The Education Resources Institute Inc (TERI), which claims to be the largest not-for-profit guarantor of U.S. private education loans, filed Monday for Chapter 11 bankruptcy protection. Thanks to borrower defaults and credit market problems, its liquidity was "damaged."

People have asked me what would be the next shoe to drop after subprime. The $85 billion student loan market is one where the supposed alchemy of securitization is turning lead into toxic waste rather than gold. Securitization was supposed to eliminate the risk of loss by bundling enough good loans with bad ones so the security would offer attractive returns. While the securitizers got big fees, the losses are turning out to be larger than expected.

Continue reading First Marblehead down 42% -- are student loans the new subprime?

First Marblehead down 42% -- are student loans the new subprime? originally appeared on BloggingStocks on Tue, 08 Apr 2008 10:10:00 EST. Please see our terms for use of feeds.

The Wall Street Journal [subscription] reports that the way bankers get paid makes them do things that hurt the economy. They get paid based on closing deals -- e.g., sales volume -- not deal quality or profit.

Gary Becker, a Nobel Prize winning economist at the University of Chicago, achieved distinction for highlighting the ways that people respond to economic incentives. His insights have sensitized me to how incentives have skewed behavior in the recent securitization bubble, and I have posted on this topic for the last year and a half (for example, here, here, here, and here).

But the Journal provides details I had never seen until now. Here they are:

• Mortgage broker gets 0.5% to 3.0% of deal volume based on loan size, types, and terms
• Lender gets 0.5% to 2.5% of loan for selling the mortgage to an investment bank
• Bank/bond issuer gets 0.25% to 1.25% of Collateralized Debt Obligation (CDO) issue
• Ratings agency gets paid by bond issuer to give the highest rating
• Bank CEO gets big pay day even as he departs for making the bad loans

Continue reading Why bankers' pay needs to change

Why bankers' pay needs to change originally appeared on BloggingStocks on Thu, 17 Jan 2008 11:12:00 EST. Please see our terms for use of feeds.

The Wall Street Journal [subscription required] compares the estimated size of the subprime mortgage crisis with other recent financial crises. About to be taken over by Rupert Murdoch, it looks determined to underestimate subprime's magnitude in order to make those responsible look less incompetent. I've estimated the subprime crisis could cost $4 trillion -- the Journal limits it to $400 billion. But the analysis can't paper over an important point -- the subprime crisis is the first to be fueled by securitization.

There are two things I like about this analysis. First, it highlights the predictable decade long cycles in the U.S. economy based on the relationship between asset prices and borrowing. When asset prices rise -- possibly based on their makers' ability to charge a higher price for them than it costs them to make -- the bankers start to lend money using those assets as collateral. But the lending drives up the asset prices beyond what they're really worth as more and more bankers pile in. Eventually, the borrowers can't pay back the loans and the banks implode along with the borrowers.

The second thing I like about the analysis is the comparison of the magnitude and costs of five crises over the last 25 years:

Continue reading Subprime mess: Securitization's first financial crisis

Subprime mess: Securitization's first financial crisis originally appeared on BloggingStocks on Mon, 10 Dec 2007 11:43:00 EST. Please see our terms for use of feeds.