Let the Bankruptcies Roll
by Michael S. Rozeff
by Michael S. Rozeff
Certain financial developments of late, commonly treated by the mainstream media as negative, are gladdening my heart. It is sheer delight to read that Carlyle Capital Corp. is unable to meet margin calls. Its stock fell from $12 to $5 in one day. I hope it goes to $0. I am happy because Carlyle is an affiliate of the Carlyle Group, which is a charter member of the corrupt military-political-industrial complex. It is the home, or former home, or palace, or safe deposit box of both Bush presidents and an incredible roster of other once high-placed officials, such as John Major, Frank Carlucci, James Baker III, Richard Darman, Arthur Levitt, and Mack McLarty, to name a few.
Carlyle invested $21.7 billion in mortgage-backed securities issued by two government-sponsored enterprises, namely, the Federal National Mortgage Association (ticker symbol FNM), known as Fannie Mae, and the Federal Home Loan and Mortgage Corporation (ticker symbol FRE), known as Freddie Mac. Carlyle used excessive leverage (issuing debt of its own) to finance these purchases. It borrowed by issuing very short-term debt known as repurchase agreements using the mortgage-backed securities as collateral. When these mortgage-backed securities fell in price, the lenders demanded more capital (margin) from Carlyle. But it had borrowed so much that it could not meet the margin calls. It received a notice of default. Wonderful!
How long the mighty fall before they manipulate the system to bail themselves out is anybody's guess. In the meantime, it is fun to see even a token victory. Half a loaf of comeuppance is better than none.
The Northern Rock bank in England issued large amounts of mortgage-backed securities, financing them by wholesale sources of short-term funds such as borrowings from other banks. In this respect, it was like Carlyle. When its short-term sources of funds dried up, the bank failed. England nationalized this bank. It should have been allowed to fail. Failures are good when they are deserved. We may not learn from them, but at least they give us the opportunity to learn. And we need to learn a great deal.
Investors who over-reached for yield and over-reached for yield spreads are learning the hard way that this was a risky policy. When yields on short-term money market funds fell drastically, the number of ultra-short bond funds doubled. These bring in extra current yield by, among other things, investing in mortgage and other asset-backed securities. Although they seem like money-market funds, they are not. A fund like Fidelity's Ultra-Short Bond Fund maintained a $10 value for over 4 years, only suddenly to drop to $8.61. (Some others have fared better, depending on their investments.)
Carlyle Capital bought debt securities of FNM and FRE, but their stocks are also falling. The stock price of Fannie Mae, which almost hit $90 in December of 2000 is down to $22. It fell over 10 percent on March 6 alone. I hope this company goes bankrupt along with Freddie Mac, which is down to $20 after being north of $70 a share. The government has no business butting into the mortgage business, so if Fannie Mae and Freddie Mac fail, good riddance.
Although I'd enjoy seeing a complete debacle occur in these two government-created monsters, quite possibly the government will prevent or otherwise forestall their bankruptcies should they ever be imminent. The government provides no explicit guarantees to these companies, and the companies state that there are no guarantees. Nevertheless, investors have acted as if the companies had some implicit guarantees. They have good reason. Congress clearly wants these companies around so that they can buy up mortgages. The political fallout from their failures would be severe.
Investors therefore have lent money to Fannie Mae and Freddie Mac at (low) rates not in accord with their risk. This has allowed these companies to create and dominate a secondary market in mortgages. They bought up mortgages originated by banks, packaged them up, and resold them as the kinds of mortgage-backed securities that Carlyle invested in. How ironic that a company with so many ex-politicos in it might be dented a bit by another government-sponsored enterprise! These securities have been turning sour because the mortgages in them are defaulting. As a result, the yields on these debts are running 3 percent higher than Treasury bond yields, as compared with a more typical 1 percent. And even that premium is not as high as other troubled mortgage-related debts.
What is this secondary market that Fannie Mae deals in? It's basically a used-item or resale market. A secondary market is a market in which buyers and sellers can trade an item, like a security, after it has been issued. The used-car market is a secondary market. So is the New York Stock Exchange.
If there is no such market or if the market is limited or thin, the security is said to be illiquid, which means that it cannot be sold or sold quickly in significant amounts at a price near to its previous price. When a market is illiquid, there is good reason for it. There may not be enough active buyers and sellers to warrant an exchange. Such a market usually becomes a dealer market.
In the good old days, banks originated mortgages and then generally kept them in house, that is, retained their ownership. They were illiquid loans. The secondary market in home mortgages was very limited.
Some items have secondary markets and others do not. There is no natural financial or economic law that says that every loan or security must have a secondary market, liquid or not. A secondary market develops spontaneously if conditions and circumstances warrant it. Otherwise, it doesn't.
Farmers used to write illiquid forward contracts to sell their corn production. Later, the futures markets, which provided far more liquidity by standardizing the contract and by other risk-control methods, came to displace the older forward contracts. Put and call markets used to operate as an illiquid dealer market and with ads in Barron's until the Chicago Board Options Exchange devised standard contracts. On the other hand, there are thousands of bonds that are unstandardized and that have illiquid secondary markets.
Entrepreneurs devise secondary markets if it pays them to. E-bay created or enhanced many secondary markets. There is no need for government to foster or encourage secondary markets where none naturally exist or where they are illiquid. In such cases, there is no secondary market because it does not pay to have one.
When the government steps in, as it did in 1938 when it created Fannie Mae, it does so to benefit some special interest groups. The government draws resources into an uneconomic use and it undermines the primary market in various subtle ways. This happened in the secondary mortgage market.
Banks used to hold mortgages and not resell them. Fannie Mae gave the banks a way to sell their mortgages. Since Fannie Mae borrowed at privileged rates, due to the implicit government guarantee, and bought mortgages from the banks, the banks benefited.
Bank capital is limited, and the amount of mortgages they can carry is therefore limited. But if a bank can originate a mortgage and then sell it to Fannie Mae, then with the same capital it can increase the number of its mortgage originations. Its profits go up. Its incentive and capacity to push mortgage loans rises. This distorts economic activity.
In the good old days when the banks both originated and held the mortgages, they faced several risks, and good bank management required that they manage these risks. They generally borrowed short and lent long. They borrowed by issuing short-term securities such as CDs. They lent by making long-term mortgage loans. The short-term interest rates they paid were usually lower than the long-term rates they received. A liquidity problem arises when the short-term rates exceed the long-term rates. Another problem arises when the long-term rates go up, as this reduces the value of the mortgages. Usually when short-term and long-term interest rates rise, the short-term rate rises more than the long-term rate, and the bank's position deteriorates.
When mortgage loans were illiquid, the bank had to be careful to maintain alternative sources of funds in case interest rates rose. It had to be careful in managing its mortgage and loan portfolio so that they were diversified. It could not concentrate too heavily in one type of loan, one maturity of loan, or one borrower.
The bank also had to maintain the quality of its mortgages, because if interest rate rises were associated with hard times or brought on hard times, then its bad mortgage loans might rise. The bankers managed these risks partly by knowing their customers. The three C's of credit were Character, Credit, and Capital. The bank looked into the borrower's past history, how much credit he could handle, and what his other assets were. The loan officer's own reputation and prospects of rising within the bank through promotion depended on his being careful in making the loans.
In recent years, the three C's became a joke. Banks made loans on no character, no credit, and no capital. Why not? They sold these loans to Fannie Mae and Freddie Mac, or to some other intermediaries who then repackaged them into pools (called securitization) and resold them to other investors. These included all sorts of institutions including large banks overseas.
The secondary market, combined with the innovations in securitization and the ready pools of money seeking high yields in a low-yield environment, altered the incentive structure in mortgage origination. Mortgage lenders no longer cared as much to whom they lent; and the guidelines for how much they loaned deteriorated.
The stocks of a heap of banks and mortgage companies are now falling in price drastically, the main reason being that they are holding bad loans. Washington Mutual (WM), a bank known for its mortgage loans in overheated markets in California and Florida, is down to $11 from $47. Citibank (C) is down to $21 from $55. They, not I or you or the taxpayer, made these bad loans, and they (and their suppliers of capital) should suffer the consequences. If those who took the loans walk away, and that is their choice, so be it. If the lenders have to deal with the costs of foreclosures, that is how it should be. Why should you or I bail them out? If we do, they will give us a repeat performance (this is called moral hazard).
I'm hoping to see the bankruptcies roll along unimpeded, but realistically what I expect is a roll call of political rhetoric, name-calling, blame-placing, and misguided government attempts to halt the truth of the ticker tape, which is that the boom is over and its excesses are now being liquidated. So I have to take what little enjoyment I can get from watching the stocks of these enterprises collapse.
A good, solid, scary bear market that chastens all concerned is just what we need, that is, if it were allowed to provide its salutary effect, which it won't. Many more people need to be taught many lessons.
Among our influential leaders, I see no evidence of any truth-telling. Was there ever? I seem to remember at least occasional flashes of truth emanating from an occasional Senator or Representative or novelist or artist. But in recent years, there is not even the smallest sign from any of the rich and powerful who command the nation and the airwaves that they are prepared to lay aside their demoniacal control over this country.
There are two Americas: the official America of endless b.s., and the real America glimpsed in the unhampered and uninhibited writings beneath the surface in the blogosphere. I do see hopeful signs of light in the blogosphere.
I will keep my computer running while I continue to make sure that my Mute button works on other media so that I can tune out the waterfall of official baloney that such bankruptcies or a grinding bear market will elicit. The rich and powerful cannot halt a bear market or all its ramifications. But, sad to say, they know how to use it to their advantage in order to propagandize and solidify still further their grip on the lives of Americans.
March 8, 2008
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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