Monday, September 26, 2011

Thank God for the Department of Transportation

Americans love cars, perhaps we are forced to, after all most of us drive every day. There have been many impressive improvements over the years. When it comes to the car we choose I believe comfort remains at or near the top of most everyone’s list. The part on the vehicle that makes a vehicle comfortable is (it’s time for the interactive part to begin so fill in the blank) ____________ the shock absorber. Imagine the opposite, how would you feel driving a car that was not comfortable, or worse a car without shock absorbers, or missing even one shock absorber? You’d be pretty miserable wouldn’t you?

Since Americans remain fascinated by their cars I hope it makes it a little easier to understand the housing bubble. How it occurred and why it is still so bad, over seven years from the peak of home ownership in 2004, five years after the peak in prices in 2006 and over three years after the Wall St bailouts in 2008 and the movie that Mr Bernanke saw the first time plays on today in his latest trifecta wager on QE.

The housing bubble was like a car that lost its shock absorbers,
Mortgage finance shock absorbers decline from 28% to 3%

Since the beginning of time, make that mortgage finance in the US in the 1930’s, borrowers nearly always had to put 20% down to qualify for a loan, after getting approved by the lender’s underwriting department. Lenders intermediated about 12 times over and above their total equity. That implies that lenders had about 8% equity stake in each mortgage loan. Adding up borrower’s down payment, known in bank underwriting parlance, as the initial loss absorbing cushion of 20% plus lender’s second loss absorbing cushion of 8% gives us a total of 28% loss absorbing cushion against any decline in the price of the home.

Total loss absorbing cushion shrank to 3% or less
When the music started playing in the 2000’s…certain lenders in arrangements with Too Big to Fail (TBTF) Banks let, I repeat let borrowers get loans with no down payment, so the first loss absorbing cushion was totally wiped out by, make that approved by, the lenders. Too big to fail banks issued almost $17 Trillion of MBS from 2001 to 2008. The TBTF banks having both nationwide and global sales teams, known as registered representatives, or as Goldman Sachs calls them “professionals” typically sold 100% of every deal off to third party investors, institutions like mutual funds, insurance companies and pension plans. However, TBTF banks started to amass trillions worth of these MBS for themselves, many concealed in a 2nd set of books. As a result of the hiding, although it was legal, nearly wiped out the 2nd loss absorbing cushion bringing it down from 8% as it had been for decades, to 3% or less.

Shock absorbers on a car are carefully engineered
Most of us drive on flat roads to and from work each day; however the engineers design the shock absorber to withstand pot holes or the occasional off road adventure. Shock absorbers play crucial safety functions when we put on the brakes or when we are going up and down hills.

When the housing market began to climb uphill, shock absorbers disappeared
As the housing market took off, rather than taking a breather it didn’t slow down, prices climbed faster and faster as home prices went up more than anyone had ever seen before, causing more and more first time home buyers to jump into the action. Many of these new home buyers were inexperienced, however, instead of requiring 20% down payments they were approved for loans with no money down, and worse, many lenders’ underwriting personnel approved every loan application; as in what’s become known as IBGYBG (I’ll be gone, you’ll be gone) passing problems whether big or small onto the next party.

As the car with no shocks, driven by new and inexperienced drivers approached the peak of the mountain, the lack of shock absorbers made for more than a bumpy ride…
The loss absorbing cushion of 20% down payments and banks 8% equity cushion fell by the wayside only after being approved by TBTF banks. Mortgage borrowers all across the country and institutional investors alike plummeted down the other side of the mountain with no shock absorbers, then the braking system became overwhelmed and it too gave out; as they are designed to work with the shock absorbers.

Banks’ Safety and Soundness regulations were blinded by the size of the bonus checks…
It’s clear that none of the TBTF banks’ prop traders or CEOs raised a hand and said it was too much or questioned the size of their bonus checks at the end of every year. No TBTF Banks' boards whether past or present, no regulator or official at the SEC, FDIC, OCC or OTS; no one on the FOMC, at the Federal Reserve Board appreciated that a car stripped of its shock absorbers makes for a bumpy, dangerous and when travelling up and back down a curvy mountain road often deadly experience. I wonder if any of the TBTF Bank CEO’s or the financial experts; Mr Bernanke, Mr Geithner, Mr Paulson, Mr Summers or Mr Rubin drive cars without shock absorbers? Thank God for them that the Department of Transportation is not part of the SEC, Department of Treasury and or the Federal Reserve Board and sees to it that automobiles are required to have shock absorbers; nothing fancy just basic safety equipment.

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