Wednesday, September 15, 2010


So I'm sitting in the barber's chair and getting my hair cut this morning. The talk turns to what's happening in the markets, and who's to blame. The standard Fox News meme emerged: "It's the fault of everyone who couldn't afford to buy a home."

My, my, where to begin ...

Why Wall Street Is At Fault ...
Let's start with this. The money had to come from somewhere. Fox News and their Republican friends may get political mileage pointing at irresponsible borrowers and Fannie Mae as the problem. But the real issue lies with people in the private sector who were creating and insuring shady mortgage contracts, as I've posted on here and here.

On this front, Wall Street knew what they were doing. Their models told them they would make money on their activities, so they pushed for more mortgages. Ability to pay wasn't really an issue. Creating marketable securities that they could bet on was.

Irresponsible borrowers? No doubt there was a problem. But we have to ask ourselves, Why was Wall Street and their financial mandarins so eager to lend to "irresponsible" borrowers?

The simple answer is that Wall Street's market players were becoming irresponsible lenders. They became irresponsible lenders because they had created a sweet ponzi mortgage scheme, built around a fraudulent insurance system.

In the first part of the scheme, as Nomi Prins outlined, between 2002 and 2008 about $1.4 trillion in subprime mortgages were issued. Out of these mortgages Wall Street created ("derived") about $14 trillion in securitized bets. In part because the underlying contracts were subprime mortgages, Wall Street needed insurance for their bets.

I'm over simplifying, but the second part of the scheme worked something like this.

* I tell you I will provide insurance for your mortgage backed securities.
* You must pay me premiums for my insurance.
* If the market collapses, "tough goat cookies ... we won't pay" (this wasn't actually said).
An illusory sense of security (insurance) plus record profits (for Wall Street) made for a euphoric market mood. So more mortgage contracts were sought, written up, and sold off to security slavery. Wall Street created it's own demand. It didn't matter who the mortgage holders were. As long as they could fog a mirror they were going to get a mortgage contract, which was going to be insured (wink, wink) somewhere down the line.

(At the time no one really knew or cared whether the insurer had the money to pay out claims. There were three reasons for this. First, Wall Street's market models said everything was OK. Second, the insured mortgage contracts were labeled as "derivative" contracts which, at the time, were largely unregulated. Finally, everyone was making lots of money).

Ben Bernanke Feeds the Fire
It was like handing the car keys to a teenager, and then being assured that everything will be fine by their loser friends, who are all carrying bottles of booze out the door as they wave good bye.

And why not? Ben Bernanke (the trusty father of the "loser friends" in this scenario) was confident that "market fundamentals were strong" and that bank regulators were doing the right thing. And, besides, national housing prices don't fall, right? Here's Bernanke making these claims before the market collapsed ...

A Ponzi Insurance Scheme + the sage (albeit, wrong) words of Fed Chair Ben Bernanke  =  a sense of market security.

This market chemistry was so soothing that Wall Street and the financial titans of America actively went out and looked for more home mortgages to issue, bundle up (CDOs), and then insure (CDSs) right up to when the market collapsed. Bonuses, sweet fees, and juicy commissions made this a win-win for everyone involved, but especially Wall Street.

"Don't Blame Me ..." Wall Street's Lack of Accountability
At the end of the day, as I pointed out here, when people stopped paying their debts and mortgages - which once gave value to the market securities that Wall Street created - what should have happened is that those who insured the securities should have paid up. Instead, they blamed irresponsible borrowers for ruining their ponzi-scheme.

Let me be clear here. When people stopped paying the debts and mortgages that made security contracts worth something, the people and institutions who provided the insurance for these contracts should have paid up.

But they didn't have to. The American taxpayer did, and will continue to do so long into the future.

MORAL OF THE STORY: Don't count your chickens before they hatch.

MORAL OF THE STORY, II: But especially don't blame Main Street for your own stupidity and greed when you create and feed a mortgage and insurance ponzi-scheme that produces profits for you but undermines the integrity of the market.

- Mark

Addendum: Congress held hearings on Fannie Mae and Freddie Mac today. It was covered by C-SPAN. As expected there were Republicans who wanted to direct blame away from Wall Street. So they tried to blame Fannie Mae and Freddie Mac for the market collapse because of how they backed reckless borrowers. Fortunately, Congressman Brad Miller (D-NC) was there to set the record straight.

He reminded Republican committee members that they once praised subprime lending as the type of innovative lending that comes from deregulated or "unfettered" markets, and because of how it contributed to a spike in home ownership. Among the points Congressman Miller brought up included:

1. When Republicans criticized Fannie Mae and Freddie Mac after 2003, they were essentially using the talking points of Fannie and Freddie's unregulated private insurer competitors (AIG, Goldman Sachs, Lehman Bros., Merrill Lynch, etc), who had financial axes to grind.

2. The private insurers were "running rings" around Fannie and Freddie in lending to and insuring affordable - or "subprime" - housing mortgages (which the data makes clear).

3. The Bush administration pressured Fannie and Freddie to purchase and insure the toxic assets of the private insurers (which constitutes a market subsidy).

There's more, but you get the point. While Wall Street is to blame, Congress had a helping hand in making the mess worse than it should have been. Miller's comments, and the complaining that led to Miller's comments, begin at 1:42 and 15 seconds here.

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