Friday, January 15, 2010

Wall Street Debacle – Was It Really Greed?

From the Desk of Joe Rollins

Time after time, I’ve read that the sole cause of the Wall Street debacle was greed. Perhaps that’s the instinctive explanation, but after reading numerous books on the subject, I’m not so sure that greed was the driving force. Clearly, greed led to Wall Street firms pushing to make the most money possible, but I doubt any of the players involved were hell-bent on making an enormous amount of money at the risk of destroying their companies. More than anything else, what I’ve read indicates that the big shots of these Wall Street firms were not very smart. Hopefully I can illustrate that point in this post.

I’ve read extensively over the last several months on the subject of the economic crisis in America, including House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, by William D. Cohan, The Sellout: How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System, by Charles Gasparino, and Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System---and Themselves by Andrew Ross Sorkin. Most of my personal thoughts on the crisis crystallized after reading these books and the 1,500 pages regarding the financial crisis.

Being an accountant by profession, I understood exactly how the implosion of these firms happened. After you break down the accounting necessary to get to why the firms failed, it’s fairly easy to see how their lack of liquidity made the major institutions blow up. However, I can’t see how people who were being compensated billions of dollars could’ve been so dumb. The only way to explain this matter is to illustrate to you how it occurred.

About 15 years ago, the major brokerage houses found a lucrative market in taking loans that Freddie Mac and Fannie Mae originated. Essentially, they would bundle up thousands of mortgage real estate loans, split the bundle into manageable pieces, and sell the securities on Wall Street. At the time, it seemed like a good deal for everyone involved, and the brokerage houses would make a nice fee for their trouble in syndicating and finding buyers for the loans. In honesty, the fees were very modest, although the absolute dollars were huge. For example, if the firm only charged 1% to syndicate loans worth $400 billion, they would earn a fee of $4 billion, an enormous amount of money by any definition.

The loans were also a very good deal for investors because they earned a higher rate of interest than typical securities, and the default rate on these securities were guaranteed by the U.S. government, making their loss rate virtually zero. This was quite a win-win situation for Freddie and Fannie since they could offload their mortgages and make new mortgages to promote new housing. Similarly, Wall Street could make a fee for the syndication of the underlying securities and investors made money on the interest rate. Unfortunately, a good idea often winds up becoming disastrous when taken to the next level.

Wall Street was doing so well with the Freddie and Fannie loans that there ended up being a shortage of these loans for all the major brokerage houses to enjoy that success. The principal firms involved in this syndication were Bear Stearns and Lehman Brothers. Later on, it was Merrill Lynch, and to a lesser degree, other brokerage firms. After they could no longer find enough Freddie and Fannie mortgages to satisfy their desire for syndication, they began seeking out direct mortgage loans from the banks to syndicate. The major difference that most overlooked is that these loans directly from consumers did not have a government guarantee. Therefore, when a loan went bad in this investment pool, it truly went bad.

The Wall Street brokerage firms were essentially agreeing with the banks to syndicate a few thousand of their real estate mortgages. They’d pick a group of mortgages where roughly 80% of the mortgage pool would be excellent loans, 10% would be loans to those with mediocre credit, and the remaining 10% would be sub-prime loans. If you place these loans on a spreadsheet, you would easily see that the likelihood of the collection of these loans in full would be great. There were only 10% sub-prime loans, and of that 10%, most of those loans would ultimately be repaid or refinanced. The 80% of prime loans would be repaid, so there would be little risk to the investors.

Wall Street would take this pool of real estate mortgage loans over to their rating agency which would look at the spreadsheets and quickly assign an “investment grade” rating to the pool. As the brokers had done previously, they would then split up the pool of real estate mortgages into smaller pieces and sell them to the investing public. The only problem was that these mortgages weren’t like the Freddie and Fannie mortgages since when they started going bad, there was no implicit government guarantee to come to the rescue.

As many of these mortgage holders found, it wasn’t long before the sub-prime loans quickly went bad. Even though the vast majority of the mortgage pool would be paying principal and interest on a regular and profitable basis, it would be a scary proposition for 10% to 15% of the entire pool to begin failing shortly after purchase. In addition, with real estate values dropping throughout the United States, the collateral obtained by foreclosing and reselling the houses made many more of the mortgages uncollectible. Even worse, many of the mortgage brokers throughout the United States were using exotic if not downright stupid mortgages to make more and more mortgage originations.

You’ve probably read about the mortgages in California where the mortgagee was allowed to choose a payment plan. If they could not make the payment in full, the principal would be increased for the unpaid amount. That shortly led to mortgages that were significantly higher than the underlying value of the houses, which were also suffering from falling prices. The perfect storm of real estate mortgages was occurring.

Accordingly, it also became fairly clear to the investing public that these mortgages were toxic. Why would you even buy a piece of a security where you had to worry about whether you could ultimately collect the principal? It simply did not make any sense for investors to invest in these securities even though the interest rates were higher. While it’s true that the interest rates carried a premium, the risk wasn’t worth the hassle to the investing public.

Now you have the framework for where I believe sheer stupidity overtook greed by a long shot. To truly understand how incredible the situation is, you have to realize the magnitude in the business plan of these major brokerage groups. First, the underwriting group made profits off the underwriting of the securities and then there was the brokerage group that would make profits by selling these securities to the open public. The risk to the brokerage house was that they would agree to buy the underlying mortgages, but could they sell them to the general public? If they were not able to sell them to the open public, then they would just have to hold them on their books until a buyer was later found.

During the height of the explosion in mortgage syndication, brokerage houses were seeking out more and more mortgages to syndicate. During 2005 and 2006 in particular, the mortgage originators in the country were making riskier loans at the insistence of the government in an effort to allow more people to become homeowners. I understand that it’s a worthy goal for everyone to own a home, but it’s not particularly bright to put people in homes that they ultimately can’t afford. As such, the Wall Street brokerage houses were syndicating more and more of these mortgages and attempting to sell them with the same success they’d had in selling the Freddie and Fannie backed mortgage pools. However, as previously documented, the public no longer wanted these mortgages.

This is where you would think that common business sense would’ve overtaken the brokerage business. It should’ve been clear to any manager that even though enormous profits were being made on the syndication of the mortgages, the mortgages couldn’t be sold to the general public. This was only leading to a deeper and deeper hole. Rather than stop syndicating the mortgages due to their inability to sell the securities to the general public, the Wall Street firms just continued syndicating new mortgages at record pace. Even not-so-smart executives could see that they were loading up their own internal balance sheets with more of these mortgages that they’d just syndicated and made good fees on.

Part of the problem was that all the major banks in New York were happy to lend billions and billions of dollars to these brokerage houses to fund their operations. Obviously it is much easier and more profitable to loan billions to one borrower rather than to loan $100,000 to a million borrowers. So, the cycle began. The mortgage loans were syndicated and the brokerage house made a nice fee. However, these loans couldn’t be sold to the general public and the brokerage houses were borrowing money from the other commercial banks in order to fund their operations. Given that the banks were borrowing money at very low interest rates and the mortgages carried rates at sometimes double their borrowing rate, the brokerage houses were pulled into a feeling of complacency that they were making a nice spread on the difference between the value of the mortgages and the value of their debt. They were so wrong!

At the beginning of 2008, all of the major financial institutions were required to value their assets at what was called “mark to market.” Before, they were valueing their assets on their books using a hypothetical valuation, which Warren Buffett often called “mark to fantasy.” I’m not going to argue whether mark to market was correct. In fact, I’ve written in the past that mark to market was incorrect. A more viable alternative would’ve been the method that is being used today – “mark to model.” It’s not as strict as “mark to market,” but certainly not as liberal as “mark to fantasy.” Rather than throw around a bunch of terms, I’d like to give you an example.

A brokerage house syndicates a pool of mortgage loans. Rather than use large numbers that no one understands, my example will use a $100,000 mortgage pool. Obviously, the amounts Wall Street would syndicate would be in the billions, not the thousands. The Wall Street investment group would buy the underlying mortgages from the originator for a fee of $98,000. They’d make $1,000 on syndicating the mortgage pool and the attorneys, accountants and other required professionals would make $1,000 as their fee to do the pool. At the end of the day, the mortgage house had $100,000 on their books available to sell to the general public.

In better days, they would’ve sold these mortgages at book value or greater and the brokers working in the company would’ve made a commission plus a profit on the sale in the open market. Since the brokerage house didn’t have adequate equity to finance $100,000 in this mortgage pool, they’d go to their local banker and borrow 90% ($90,000). On the books of the brokerage house, they’d have $100,000 in mortgages earning 8% and a loan to their local bank at $90,000, on which they were only paying 4%. They were enjoying the ultimate 4% carry trade difference between their earning capacity and their cost of money until they could arrange for a sale to the general public.

Since these assets were on the books of the brokerage house as inventory and available for sale on the open market, they were valued at cost on what they originally paid for them of $100,000. With the beginning of “mark to market” accounting, the dynamic suddenly changed. What is the value of an asset no one wants to purchase? Suddenly all the brokerage houses have literally billions of dollars on their books for these mortgages that the general public didn’t want to buy. What is even more interesting is the brokerage house should immediately quit syndication until they immediately caught up selling these assets. However, due to a lack of management, they did not quit. In fact, they accelerated syndicating the mortgages because of the enormous fees they’d make on the underwriting even though they couldn’t sell them to the public.

Beginning in 2008, the brokerage houses were required to establish a fair market value on the underlying mortgage pool for the general public. Before the mortgages had been valued at $100,000, which of course, they owed $90,000 against. Beginning in 2008, since they were required to value these mortgages at fair market value when they had zero marketability, many of the mortgages were written down. At first, they were written down 30%, then 40%, and oftentimes, many of them were valued at 40% of face value. Even though the vast majority of these mortgages would be collected, since no one wanted to purchase them, they had to be valued at a significant discount – say 50%.

The Wall Street brokerage houses suddenly had $100,000 on their books in mortgages that were valued at $50,000, yet they owed $90,000 on those mortgages. In an instant, they became insolvent and went totally “under water.” Even though it was clear that these mortgages were making every major brokerage firm write down their asset base, they continued to underwrite more and more mortgages, creating the real estate boom while destroying their own balance sheets.

This insolvency overtook the financial framework of America very quickly. On March 5, 2008, the Bear Stearns Companies announced a profit of $115 million for the first quarter of 2008. In that press release, they documented that they had $17.3 billion in cash on hand and boasted that they had been a colossally profitable enterprise in the eighty-five years since its founding. Ten days after that announcement, Bear Stearns no longer existed. It was only the first of the major brokerage houses to meet such an untimely death.

Interestingly, those who were hurt the most in the ultimate demise of these brokerage houses were the New York banks themselves. Poetic justice? They were loaning the money, funding the brokerage houses to make the loans, and the brokerage houses that took the losses and defaulted on the loans. It’s amazing how little Main Street was actually impacted at that time due to the Wall Street executives’ complete lack of intellect.

It’s incredible that the executives of these firms were all so naïve that they couldn’t see this disaster on the horizon. Clearly, some major brokerage houses – in particular, Merrill Lynch – continued to syndicate these toxic mortgages long after there was absolutely no market for anyone to purchase them, losing 50% on every one that was syndicated.

By virtue of realizing billions of dollars in profits during the “Go-Go Years” of 2003 through 2007, the executives on Wall Street accrued bonuses worth billions. The public is likely not aware of the fact, however, that virtually all of these bonuses were paid in the common stock of the companies. These executives felt invincible, and even though they were paid relatively modest salaries, most of their compensation was paid to them in the stock of their own companies. Due to the egos and company pride these executives developed the vast majority of them never sold their common stock. In fact, many of these executives were holding their common stock when the companies blew up right before their eyes.

I’m not suggesting that any of us should feel sorry for these executives. I simply question that they acted in greed when they held onto their common stock even as their companies imploded around them. For example, James Cayne, Bear Stearns’ CEO from 1993 through 2008, had common stock in the company that was worth $1.7 billion in 2007. Shortly after Bear Stearns was sold to J.P. Morgan Chase & Company, Cayne sold all of his stock for $61 million. Obviously, $61 million is a large sum of money, but you must remember that this is the entire amount of his compensation for a lifetime of work in the company he practically built.

Likewise, Richard S. Fuld, Jr., the last Chairman and CEO of Lehman Brothers Holdings, was never accused of being stupid. However, his lack of managerial ability forced Lehman Brothers into bankruptcy in September of 2008. At one time, Fuld’s stock ownership in Lehman Brothers had been valued in excess of $1 billion. Never in his long career had he ever sold even one share of his common stock in the company. When Lehman Brothers declared bankruptcy in September of 2008, he got exactly zero for his common stock.

The press likes to talk about the sheer greed of these Wall Street executives. Rarely do you read that ultimately, the biggest executives never shared in those riches. Even though these men had taken these companies to lofty heights, they didn’t have the intellect or managerial ability to understand their own companies. Each sat by and watched as their company imploded and was essentially sold for pennies on the dollar.

There’s no question that greed was a component in the failure on Wall Street. However, greed is a driving force in virtually all business endeavors. Whether or not you’re willing to admit it, why would someone be in a business venture if they did not strive to succeed? In my mind, the greed is an element of ambition. Of course, some of these executives retired from Wall Street with billions of dollars in their pockets, but just as many who got rich wound up virtually penniless.

I intend to write further in an upcoming post on the compensation of bankers and the ridiculous new tax proposed by the Obama Administration. It puzzles me that a tax would be assessed on the 50 largest financial institutions to get back the TARP money. The banks have already paid back their government loans with interest. However, GM, Chrysler and AIG haven’t repaid their loans. Interestingly, those folks aren’t being taxed. Again, there will be more to come on this subject from me in the weeks ahead.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

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