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The Mortgage Wars
Inside Fannie Mae, Big-Money Politics, and the Collapse of the American Dream
By Timothy Howard McGraw-Hill Education
Copyright © 2014 Timothy Howard
All rights reserved.
ISBN: 978-0-07-182109-4
CHAPTER 1
The Financial Market Wildfire
On September 16, 2008, the consequences of five years' worth of unchecked lending excesses in the U.S. residential mortgage market flared up to ignite the worst financial crisis in modern history.
Barely a week earlier, the Treasury Department had put the mortgage giants Fannie Mae and Freddie Mac into conservatorship—effectively nationalizing them—expecting that this would contain the spreading effects of the mortgage market collapse. It did not.
The investment bank Lehman Brothers came under pressure almost immediately. Treasury and the Federal Reserve worked feverishly to find a buyer for Lehman, but having already put taxpayer money at risk in the rescue of another investment bank, Bear Stearns, six months earlier, and having just committed taxpayer money in the takeover of Fannie Mae and Freddie Mac, they were insistent that any acquisition be done without government assistance. London-based Barclays came close to an agreement on a deal for Lehman but pulled out when their regulator refused to approve it for fear of worsening the United Kingdom's financial problems.
Lehman filed for bankruptcy at 1:45 a.m. on Monday, September 15. That same day, Merrill Lynch announced it had agreed to be acquired by Bank of America.
The situation worsened quickly. The insurance firm AIG, with over $1 trillion in assets, was running out of money. A subsidiary of AIG, AIG Financial Products, had used complex derivatives to insure huge amounts of high-risk mortgages under the assumption that it would experience few if any losses on them, and that bet had gone horribly wrong. Counterparties to AIG were asking it to post collateral against the mounting value of its likely mortgage losses, and AIG did not have that collateral and was unable to borrow to obtain it. AIG had come to the Federal Reserve to ask for help. The Fed was inclined to give AIG a loan—both because the Fed believed AIG had enough value in its insurance subsidiaries to ultimately repay it, and because the Fed feared the repercussions of an AIG failure. The amount AIG was asking for was staggering: $85 billion.
As the Fed was considering the request, the financial markets were reeling from the Lehman bankruptcy. The Dow Jones average had fallen more than 500 points, and trading in the short-term commercial paper markets had come close to a halt.
Tuesday, September 16, was when everything fell apart. That morning Lehman's bankruptcy administrator in the United Kingdom froze all of Lehman's assets in the U.K. This was completely unanticipated, as it was contrary to how customer assets were treated in a U.S. bankruptcy. Fearing that the failure of any investment bank would lead to a freezing of assets, hedge funds responded by removing tens of billions of dollars of their custody accounts from Morgan Stanley, Goldman Sachs, and even Merrill Lynch. For similar reasons, institutional investors stopped lending securities to one another through what was called the repurchase market, which provided liquidity essential to the smooth trading of bonds and stocks.
After the stock market closed, the Reserve Primary Fund, a $62 billion money market mutual fund with over half its assets in commercial paper ($785 million from Lehman Brothers), announced that its net asset value had fallen below $1 per share. In mutual fund parlance, it had "broken the buck," meaning that its investors would not get all of their money back.
Then, at 9 p.m. that evening, the Federal Reserve announced that it had made a two-year, $85 billion emergency loan to AIG, a company most people never had heard of, to keep it from failing.
A financial system cannot function without the confidence of its participants, and in just two days confidence in almost every major U.S. financial institution had evaporated. Very few companies had walled themselves off from the problems in the mortgage sector, and after the Lehman bankruptcy, everyone feared there might be no government assistance forthcoming for many of the firms that could fail in the coming days and weeks. Investors and creditors did not want to try to guess which would be saved and which would not. They wanted out of all of them, and they fled corporate debt in droves for the safety of short-term Treasuries. Overwhelming demand for these securities pulled their yields down to almost zero.
It was not just companies that were in danger of failing—it was entire markets. Money market mutual funds had $2.7 trillion invested in them, $1.5 trillion of it by individuals. Outstanding commercial paper—a critical source of financing for large U.S. corporations—totaled $1.8 trillion. And according to the Bank for International Settlements, an incomprehensibly large $600 trillion worth of assets worldwide were used as the basis for contracts in over-the-counter derivatives. AIG's activities and operations coursed throughout that unregulated market in ways few understood, which was why rescuing AIG had been imperative.
In the wake of the news from the Prime Reserve Fund, all money market funds, not just those with exposure to Lehman, were hit with unprecedented requests for redemption, and even the highest-quality corporations were unable to sell their commercial paper. In response to both problems, the Fed and Treasury announced two new programs on Friday, September 19. Treasury said they would guarantee a $1 net asset value for money market funds, for a fee paid by them, and the Fed said it would make loans to depository institutions for use in purchasing high-quality commercial paper from these funds. Together, the actions stopped the runs on money market funds, gave support to the commercial paper market, and bought the Fed and Treasury precious time to address the urgent liquidity and capital problems of the large investment and commercial banks.
On Thursday evening, September 18, Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke had gone to Capitol Hill to brief congressional leaders on the financial crisis and tell them they would be requesting "hundreds of billions of dollars" to recapitalize the banks by purchasing toxic assets. It was a high-stakes gamble on their part. Seven weeks before a presidential election, the secretary of the Treasury and the chairman of the Federal Reserve were asking Congress to authorize a massive bailout of Wall Street at taxpayer expense. If Congress turned them down, the crisis could spin out of control. But they felt they had no choice. The Fed could make loans to stave off liquidity problems, but neither it nor Treasury could put capital into failing firms. For that they needed Congressional permission.
As Paulson and Bernanke sought broader powers, the crisis continued unabated. Investors picked Morgan Stanley as the next investment bank likely to fail and Washington Mutual (WAMU) as the next depository institution. Morgan Stanley's immediate problem was liquidity. The Fed could deal with that for the moment, but ultimately the firm would need either a buyer or a major infusion of capital. WAMU's problem was capital. They had been one of the most aggressive mortgage lenders—specializing in a very risky form of adjustable-rate mortgage called the "pay-option" ARM—and were paying the price. In the week following the Lehman bankruptcy, depositors pulled over $15 billion from WAMU, putting them on the verge of collapse.
On September 25 the government seized WAMU, and on the same day JP Morgan agreed to acquire WAMU's banking operations from their receiver, the Federal Deposit Insurance Corporation (FDIC), for $1.9 billion.
The FDIC was obligated to cover any losses of WAMU's insured depositors, but it did not agree to cover the losses of their uninsured creditors. That gave unsecured depositors at other troubled financial institutions a strong incentive to flee them. The next depository institution in the domino line was Wachovia, the nation's fourth largest bank by assets and the third largest by deposits. Like WAMU, they held large concentrations of pay-option ARMs. The run on Wachovia began the day after WAMU was seized.
Wachovia would not have been able to survive on its own. In a quick policy reversal, the FDIC agreed to use its funds to protect Wachovia's uninsured creditors by invoking for the first time what was called the "systemic risk exception" under the FDIC Improvement Act.
With expanded FDIC assistance, Wells Fargo and Citigroup both made bids for Wachovia. The FDIC deemed Citigroup's bid to pose less risk to its insurance fund, and early on Monday, September 29, it announced that Citigroup would acquire Wachovia.
The good news from that event did not last even a day. Treasury and the Fed had put together a formal proposal to Congress for their Troubled Assets Relief Program (TARP), which now had a price tag of $700 billion. Negotiations over TARP had been arduous. With an eye on the political campaign, members of Congress had insisted on a host of provisions and restrictions, including limits on executive compensation for companies receiving TARP money. Those issues finally were worked out, and on the afternoon of September 29, a bill was brought to the floor of the House for a vote. Both presidential candidates, Barack Obama and John McCain, pushed for passage of the bill, but it failed, 228–205.
That failure was a devastating blow. In reaction, the Dow Jones average fell a record 778 points, its largest one-day fall ever, wiping out more than $1 trillion in stock market value.
The stock market's reaction, together with modest changes to the proposal, seemed to make a difference. Two days later, the Senate passed a revised TARP proposal, 74–25, and on Friday, October 3, the House passed it by a vote of 263–171.
But the markets continued to fall. Treasury had congressional authority to spend the money, but they did not yet have a program for buying troubled assets, and it was not clear when they would develop one. In fact, they never did.
Shortly after TARP passed, Treasury changed their strategy. Rather than recapitalize banks by buying their bad assets, they would try to shore up investor confidence by putting capital into the banks directly. On Columbus Day, October 13, Paulson summoned to Washington the heads of nine major financial institutions—four banks (Bank of America, Citigroup, JP Morgan, and Wells Fargo), the three remaining large investment banks (Morgan Stanley and Goldman Sachs, which on September 21 had become bank holding companies, and Merrill Lynch, which Bank of America had agreed to acquire), and two important clearing banks (State Street and BNy Mellon).
Paulson told them he wanted them all to accept equity from the government. To avoid the perception of nationalization, he did not make the capital mandatory, and to encourage participation, he sought to make its terms attractive. Treasury would purchase preferred stock that would pay a 5 percent dividend for five years (before stepping up to 9 percent to encourage repayment), although at the insistence of Congress, participating companies would have to agree to restrictions on their executive compensation and corporate governance.
Not all of the bankers believed they needed the capital, but they understood the importance of the signal Treasury was trying to send, and all agreed to take it. In a further attempt to bolster confidence, the FDIC at the same time temporarily guaranteed new issues of unsecured debt by bank holding companies and also guaranteed non-interest-bearing deposits at insured financial institutions. And later that week, Treasury made TARP funds available to a broad group of financial institutions on the same favorable terms given to the nine large banks.
At this point, Treasury, the Fed, and the FDIC had done everything they could think of to prevent the financial system from collapsing. In addition to TARP, they had put in place more than two dozen emergency financing or guaranty programs, totaling trillions of dollars. Still, it had not been enough. Investors were setting their sights on the most iconic bank in the world: Citigroup.
Citigroup had stayed under the radar earlier in the crisis, mainly because other banks seemed like easier targets. Ironically, it was the resolution of the Wachovia situation that put the focus on them. Three days after Wachovia had accepted Citigroup's takeover offer, Wells Fargo used a favorable tax ruling made by the IRS two days earlier to come back with an offer that not only gave a higher price to Wachovia but also posed less risk to the FDIC.
With the FDIC's approval and over Citigroup's objections, Wachovia accepted the Wells offer. Losing the Wachovia deal meant Citigroup would not be acquiring that bank's very large base of depositors and would remain heavily dependent on purchased money for funding. Of the largest three remaining U.S. banks—Bank of America, Citigroup, and JP Morgan—Citigroup's reliance on this "hot" money, combined with their greater exposure to high-risk mortgages, made them the most vulnerable.
By the middle of November, short sellers succeeded in driving the price of Citigroup stock into the single digits, and depositors were rapidly withdrawing funds from the bank. It was clear to everyone that if the government did not do something, Citigroup would fail.
On Sunday, November 23, the Fed, Treasury, and FDIC put together a rescue package for the bank whose key components were a loss-sharing agreement between Citigroup and the government that effectively guaranteed a pool of $306 billion in high-risk assets and a further injection of $20 billion in TARP money in exchange for preferred stock paying an 8 percent dividend. Regulators held their breath, waiting for the stock market's reaction on Monday. The market liked what it saw, and Citigroup's stock rose almost 60 percent.
It had been a very close call, but the financial system had survived. The American home buyer and the U.S. economy, in contrast, fared much worse. Millions of people lost their homes to foreclosure, and the economy was plunged into an 18-month recession that was deeper than any since the Depression, from which the country still is struggling to recover.
The financial crisis began in the U.S. mortgage market. It had spread so quickly and so intensely because, like a wildfire, it had found so much tinder to burn. That tinder, of course, was the hundreds of billions of dollars in high-risk home mortgages made over the previous five years that were sitting on the balance sheets of virtually every major financial institution in the country. Many of these mortgages were unlikely ever to be repaid, and most of them never should have been made.
This was the great irony of the financial crisis. The policies and the regulatory stances of the "heroes" of that crisis, the Federal Reserve and the Treasury, were among the principal reasons such a tremendous number of toxic home mortgages existed in the first place.
CHAPTER 2
The Largest Credit Market in the World
A million dollars is a lot of money. Eleven trillion dollars is an unfathomable amount of money. By way of comparison, a million seconds is about a week and a half; eleven trillion seconds is almost 350,000 years.
Just before it collapsed in 2008, the U.S. home mortgage market exceeded $11 trillion in size. It was the largest credit market anywhere. The dollar value of outstanding U.S. home mortgages was 20 percent greater than the country's national debt.
The crisis that almost brought down the global financial system had its origins in a no-holds-barred political fight among giant financial companies and their regulators over who would have the dominant position in this market—and the profits that went along with it.
As the top risk management executive at one of the principal combatants, Fannie Mae, I witnessed that fight firsthand. I ran Fannie Mae's largest and most controversial business—its mortgage investment portfolio—for 15 years and for over a dozen years was responsible for evaluating and pricing the company's mortgage credit risk.
The mortgage fight was rooted in a fundamental disagreement over the role of the government in housing. Supporters of the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, argued that housing was sufficiently important to society that the government should sponsor special-purpose institutions to provide low-cost financing to home buyers on an advantaged basis. The GSEs' opponents argued that their activities distorted capital flows and subjected taxpayers to unnecessary financial risk. The disagreement was ideological, but what fueled it was money. At issue was whether the GSEs or fully private firms—principally commercial banks and bank-owned mortgage companies—should be allowed to control the largest single credit market in the world.
(Continues...)
Excerpted from The Mortgage Wars by Timothy Howard. Copyright © 2014 Timothy Howard. Excerpted by permission of McGraw-Hill Education.
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