by guest author Chris McConnell
This article is based on a post at The Political Commentator.
TBTF (too big to fail) banks kept a massive secret from other market players, as well as regulators. In academic circles it’s called an “information advantage.” Joseph Stiglitz won a Nobel Prize for it in 2001. As Stiglitz said during a press conference held at Columbia University shortly after being awarded the prize:
“Market economies are characterized by a high degree of imperfections. Older models assumed perfect information, but even small degrees of information imperfections can have large economic consequences. Our models took into account asymmetries of information, which is another way of saying ‘Some people know more than others.’ “
The following saying is not intended to be subtle: “If you want to play on the varsity team you work at Goldman or Morgan Stanley; underachievers take jobs at ratings agencies. (The bankers know the underachievers as they once competed with them in grad / business school.)”
Step one on the slippery path for the TBTF banks started due to rapidly declining profits from traditional revenues streams like commissions, mergers and acquisitions (M&A) and investment banking. The banks changed their business models, as Morgan Stanley’s John Mack stated to Stanley Druckenmiller in 2003. (Mack said “the agency business model is dead.”) The business model changed from one of financial intermediation to non-intermediation. Proprietary trading became the destination for Morgan Stanley and others.
Let’s call a spade a shovel because that’s what it is. I’ve made an end-to-end analysis of the housing and mortgage finance markets, spanning mortgage origination to securitization and distribution. In the years before 2008 a real market for real-estate did not exist. Why? A real market is defined as transactions among arms-length, unrelated and informed buyers and sellers. The securitization process devolved into a “who got the largest” bonus check casino among prop traders.
TBTF banks, before 2008, created a hidden/secret “market” for Mortgage-Backed-Securities (MBS ):
- As stated above TBTF banks changed from financial intermediaries to non-intermediaries via turning their prop trading units into speculators.
- They hid (the FDIC used the word concealed) trillions of MBS off their balance sheet.
- They allowed their own internal prop traders to value #2 (MBS) above all else (legal under the SEC’s 2004 CSE program), despite the fact that few, if any, of them had EVER seen the light of a “market” trade – one between arms-length parties.
- Why? To maximize those SAME prop traders’, managers’ and CEOs’ cash bonus checks.
- All based on the assumption (an almost religious belief) that national median home prices had NEVER gone down. (Which was actually true, as you may recall.)
- But the past had operated under a 60 times house financing leverage regime (20% down payments, verified job, income assets and 12 times leverage on bank balance sheet).
- TBTF banks single-handedly created 3,000 times leverage on house prices, the underlying collateral of any MBS and/or further derivative.
- 3,000 times leverage is the product of zero-down loans; 100 times leverage for the borrower multiplied by 30 or more times leverage from on and off the balance sheets of TBTF banks.
- J. Kyle Bass, Managing Partner at Hayman Advisors, testified before the FCIC in January 2010 that almost all leverage at TBTF banks at the end of 2007 – yes, end of 2007 (here – see page 13) – was over 30 times, with Citigroup at 68 times leverage; which meant an adverse swing (in the value of the underlying collateral) of as little as 1.5% could wipe them out completely – insolvent.
- And we know that leverage worsened IN 2008… and we know from Goldman’s collateral call dispute with AIG that MBS marks (not even collateralized-debt-obligations – CDO’s) were south of 90…
- It’s not about Fannie or Freddie either – they were downstream of information from the TBTF banks. Again, TBTF banks held trillions of MBS, in secret OFF balance sheet vehicles. I’m not saying it was necessarily illegal, but it was fraudulent; as it was knowing, willful and intentional. It only went on as long as it did BECAUSE they were hidden.
Along the way EVERY mortgage borrower was defrauded due to the concealment of TBTF banks, and also every other party connected to mortgage borrowers – including real estate agents, appraisers, mortgage brokers, some originators, home builders, developers, cities, states, and I believe the ratings agencies.
Ask your neighbors, mortgage borrowers and their agents, appraisers, title insurers what leverage means. Ask them if they know that putting 20% down is 5 times leverage and that ZERO down is 100 times leverage (Actually it is infinite leverage, but 100 is large enough for this discussion.) It’s my belief that the overwhelming majority, if not nearly all, of mortgage borrowers do not understand their own leverage let alone how banks leverage their balance sheets. This points to the root information (really education) advantage of the perpetrators, and TBTF banks knew who they were dealing with all along.
Who knew what and when did they know it?
What we have had is a financial system cover-up, a la Watergate, at certain if not all TBTF banks.
There’s more but that’s probably enough for now.
Again – In the years just before 2008, a real market for Real Estate did not exist; lather, rinse, repeat…
Is there perhaps a small connection to the fact that from 2001 to 2008 $17 Trillion (not a typo) of MBS were issued? I’m not even counting the trillions of CDOs and knock on derivatives.
If you want further evidence that TBTF banks hoodwinked even the Federal Reserve chairman – the world’s chief banking regulator – see “One year, One Trillion Dollars – the education of Ben Bernanke 2007 to 2008…”.
Author’s note: 3,000 times leverage is only a rough estimate as not all mortgages were zero down, just several million too many – not to mention “every app was approved” underwriting. But we do know that 60 times leverage (on house prices) was the norm for decades – also called safety and soundness. And we also know that leverage at TBTF banks, assuming their year-end 2007 marks had been accurate when the Goldman/ AIG dispute timeline suggests otherwise, were understated. Again, the pressing need for CASH infusions from the Fed and US Treasury in 2008/9, as well as kinder, gentler accounting treatment courtesy of SEC/FASB also stand in evidence.
Further note from the author: Since mortage borrowers did not put a gun to the head of ANY banker to approve a loan, the title of this article could very well have been: “Every Mortgage Borrower and Every MBS Investor Defrauded by TBTF Banks’ Hidden 3,000x Leverage”
Related Articles
Analysis articles about mortgages
Analysis articles by William K. Black
Opinion articles by William K. Black:
About the Author
Chris McConnell AIFA® is an independent expert on the securities industry and fiduciary responsibility. He has over 28 years of experience. Since 2003 as an independent expert consultant, McConnell’s FiduciaryFORENSICS® service assessing liability and damages has assisted both plaintiff and defense counsel as expert witness or consultant on banking, insurance, securities, hedge funds, derivatives, intellectual property, compensation, valuation and pensions involving trusts, IRAs, ERISA, Taft Hartley, foundations, regulatory agency, family law and divorce matters. He holds a BA degree in Economics from Rutgers University, an MBA from Pepperdine University, an AIFA® from the Center for Fiduciary Studies and has extensive accounting experience including successfully passing the Uniform Certified Public Accountant examination. More information at http://www.jurispro.com/ChrisMcConnell and http://www.fiduciaryexpert.com/
