From the AEGIS e-Journal, Volume 12 Number 6, June 2009
The Looting of America Les Leopold Chelsea Green Publishing ISBN: 9781603582056 224 pages $14.95 http://www.chelseagreen.com/ 1-800-639-4099 There are many theories about why we went into the current economic nosedive. One commonly heard explanation is that the Community Reinvestment Act (http://ecfr.gpoaccess.gov/cgi/t/text/text- idx?c=ecfr&sid=635f26c4af3e2fe4327fd25ef4cb5638&tpl=/ecfrbrowse/Titl e12/12cfr228_main_02.tpl) forced banks to make bad loans to people who couldn’t realistically afford their houses, and that this, in turn, took the world down. While this is an attractive theory, there are a few flaws with it. For a start, this is the Community Reinvestment Act of 1977, and if something were flawed with the Act, it certainly should have taken less than thirty years for this to come out. Second, the Act was designed not to encourage loans to the unqualified, but to stop redlining, the practice of arbitrarily denying or limiting financial services to specific neighborhoods (draw a red line around the area), ÆGIS, June 2009 6 generally because its residents are people of color or poor. In fact, the Act specifically says: “Safe and sound operations. This part and the CRA do not require a bank to make loans or investments or to provide services that are inconsistent with safe and sound operations. To the contrary, the Board anticipates banks can meet the standards of this part with safe and sound loans, investments, and services on which the banks expect to make a profit. Banks are permitted and encouraged to develop and apply flexible underwriting standards for loans that benefit low- or moderate-income geographies or individuals, only if consistent with safe and sound operations.” Third, as chance has it, only twenty percent of the sub-prime loans were issued by institutions subject to regular examination or supervision. Eighty percent of the sub-prime loans were made by institutions not subject to regular examination or supervision. Finally, losses attributed to sub-prime loans and Alt-A loans from all sources were less than $300 billion. So if the CRA isn’t responsible, what is? In The Looting of America, Les Leopold presents an alternative theory, which we will try to summarize here, without commentary. This will be a longer than usual review, because the subject matter requires some elucidation. Leopold says that in the past it was believed by economists that real wages were tied to productivity: As productivity rises, wages rise. This held true until the mid-1970s, at which point the two diverged, with productivity roughly doubling in the last three decades, and real wages falling almost twenty percent from a high of $746 per week in 1973 to $612 in 2007. So if productivity indicated that wages should be $1,171 but were only $612, where did the extra $559 per week per wage-earner go? It went to what we will refer to as the investor class. In 1973, when productivity and wages were roughly in synch, the top one percent of earners took in eight percent of the nation’s income. By 2006 the top one percent of earners took in almost twenty-three percent of the nation’s income. So, what did the investor class do with this money, which, were it in the hands of employees, would have been spent on goods and services? They invested it. ÆGIS, June 2009 7 There is a limited investment market for existing tangible goods and services. While investment in new tangible goods and services is certainly possible, an attractive alternative was presented by investment bankers in the form of high-return exotic financial instruments like swaps and derivatives (by coincidence, this editor worked for UBS in Swaps and Derivatives), which may have no real connection to the real economy of tangible goods and services. Let us simply say that derivatives are financial instruments derived from something else, but not owning the something else. Thus, you could buy derivatives based on the Dow Jones Index or the Franc, but no stocks or Francs underlie the security. While these financial instruments can provide hedging (which can be good), they are unregulated and can allow casino-like speculation (which, as recent events indicate, can be bad). So how could a $300 billion loss in the sub-prime mortgage market trigger a worldwide economic collapse? To understand this, we need to start with mortgage backed securities, in which the Government National Mortgage Association buys bunches of mortgages from banks (so the banks have more money to lend). They then bundle these into securities guaranteed by the government at a set interest rate. The downside is that if homeowners pay back their mortgages (possibly by refinancing if interest rates fell) these mortgages disappear from the pool, and the investor might be given his investment back early, making the income stream unsure. But sub-prime mortgages didn’t qualify for federally guaranteed repurchase, because they were so risky. But that made them good candidates for investment banks because higher risk means higher interest rates. The problem was that the underlying mortgages were junk, and wouldn’t be able to get good ratings, limiting their market. Enter the Collateralized Debt Obligation or CDO (an offspring of the Credit Default Obligation, created according to the book, by Michael Milliken). What the financial institution does is buy a bunch of sub-prime and Alt-A mortgages and securitize them. But unlike what is done by Ginny Mae, instead of there being one class of security there will be three. The top level gets first dibs on all the interest payments coming out of the pool, and has a lower rate of interest. The middle level gets dibs on anything not used by the top level. It is riskier, and so has a higher interest rate. The bottom group therefore has the highest risk – there may be no interest money left – and the highest interest rates. The folks putting these deals together were able to convince the rating agencies (see our article on rating agencies in the February 2008 issue of ÆGIS) that the top tier deserved an AAA rating, making them investment grade, and ÆGIS, June 2009 8 purchasable by pension funds, insurance companies, banks, and the like, who would otherwise be prohibited from buying them. Since they paid more than a standard AAA security, but had the same AAA rating which in theory made them as safe as the government-backed mortgage backed security, they were a great deal, and nobody could be faulted for buying them. Putting aside the minor detail that the underlying commodity was junk, it therefore made more sense for an investor to put money in these high-return AAA financial instruments than to invest in lower-return tangible goods and services. Now, here is where Leopold’s story starts to get interesting. These CDOs are a great business. Certainly much better than the mortgage backed securities from institutions liable to be facing constant government scrutiny, such as those institutions for which CRA reporting is required. So there is increased demand for sub-prime and Alt-A mortgages, with riskier and riskier loans being issued. But what happens if you can’t sell all of the lower-level section of your CDOs? You form a new CDO – a CDO Squared – in which you pool all the crap from your other CDOs that you couldn’t sell because it was too risky. Then you get the rating agencies to bless the top level as highly safe AAA. If you can’t sell all of those, you do a CDO Cubed, where you gather the s**t that didn’t pass muster into a new CDO, and again get the rating agencies to say the top tier is AAA. So you have junk you are selling in a CDO as AAA, crap you are selling in a CDO Squared as AAA, and s**t you are selling in a CDO Cubed as AAA. The problem, of course, is that the investment house still owns a lot of risky mortgages, and would like to protect itself from loss. So the financial wizards tied the CDO to credit default swaps CDSs are essentially taking out insurance. That is to say you as originator of the CDO put up some annual fee for the swap, and if there is a default you get paid the whole amount owed from the swap. This allows the financial institution to get rid of their risk entirely. How? Simple! Let us say you have a pool of $100 million of sub-prime and Alt-A mortgages. You form a new financial instrument, your swap, into which investors will pour $100 million, which you put into interest bearing government securities. You, in turn, will make quarterly payments, partly funded by your safe investment of the investors’ money, into the fund, to be distributed to the investors in the swap, the top tier of which you get blessed as AAA. Those holding top-tier notes get less than those in the middle tier, ÆGIS, June 2009 9 who get less than those who own the bottom tier. If there are defaults, you simply take the money out of the SWAP. OK, so financial institutions have sold $300 billion of defaulting mortgages because they get points, and then move them to packagers who transmogrified a part of them to AAA. It is clear how investors in the lower- level slices lose money. But how do we go from $300 billion to half the world’s economy? Now Leopold’s story gets really interesting. It is a real annoyance to collect and maintain the pool of sub-prime and Alt-A mortgages, but you may recall that we said earlier that derivatives can be derived from something else to which you have no direct ownership. You will also recall that we said earlier that there was investment money looking for better returns than they would get in new tangible goods-and-services investments. So you create a synthetic CDO, which looks, smells, and tastes just like the real thing, only it is based on mortgages that someone else owns. You sell the covering default credit swaps, put the money in government securities, and if mortgage holders default – on someone else – you get to take the money from the swap! How cool is that! Not only that, but you can make as many of these as you wish, without the pesky annoyance of dealing with real mortgages. How often can you pull this off? Leopold offers no number, but does note that financial instruments with no connection to goods and services have a nominal value of roughly ten times the global GDP. This takes us rather neatly from $300 billion to about $1.6 trillion of bank losses. Plus, of course, all the losses to investors. Plus the other losses associated with unregulated financial instruments not backed by real things like goods or services. Note that in Leopold’s view the losses are not caused by mis-pricing of the derivatives because of errors in the implementation of banks’ Black-Scholes models. Nor are they caused by the over-use of consumer credit caused by the combination of below-expected wages and ready investment capital. Rather, it was caused by the simple fact that when you are gambling in unregulated markets – and unregulated financial instruments not based on owned goods and services is gambling – you sometimes lose, and unlike regulated markets, like commodities markets, where there is nightly settlement, the loss potential has little to control or limit it. Leopold includes two final chapters in which he offers suggestions about what should be done to minimize the effect of financial markets in the future. But this is just a review, so we will leave that for your reading of the book. ÆGIS, June 2009 10 7. 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