Page 2 of 3 The Treasury's moral black hole
By Julian Delasantellis
out that the situation in housing was bad and getting worse and would have
important implications for the banking system and the broader economy."
Once again, in contrast to those who say that president Jimmy Carter's advocacy
of the Community Reinvestment Act that sought to provide mortgage finance to
deserving low income and minority borrowers in the late 1970s was nothing but a
"Manchurian Candidate" type plot to torpedo the economy 30 years in the future,
in reality, it was the mad rush to over- leverage, symbolized by the 2004 SEC
decision, that really drove the real estate market, and then the financial
system and then general economy, past the point of no return.
Perhaps the only person actually working on Wall Street when the
crisis broke in early August of 2007 was CNBC's Jim Cramer; instead of being at
the beach, he was on TV staging the nervous breakdown over tight Federal
Reserve policy that introduced many Americans to the crisis. Swagel, along with
the rest of the government, was vacationing at Rehoboth, Delaware, and similar
spots while watching their world collapse with every successive Blackberry
message.
With the crisis becoming so serious that White House voices opposed to
providing assistance to "undeserving" borrowers were silenced, Swagel notes how
the Paulson Treasury settled on a two-track approach following the crises of
summer 2007. One was to try to arrange and provide for some sort of mortgage
forbearance to keep in their homes those homeowners who were threatened with
foreclosure. The other track was to resuscitate and recapitalize the banking
system through the purchase from the bank's portfolios of mortgages and
mortgage-backed securities that had declined in value.
I've written here many times on how the Paulson Treasury essentially failed in
both these approaches.
With securitization and hyper leverage of mortgage backed assets, with each
step away from the deal between the original borrower and lender, after a while
nobody really knew who was actually holding the note, that is, receiving the
mortgage payment, that was being sent in every month from the borrower. This
tendency was exacerbated by the newfangled process called "tranching", slicing,
dicing, splitting and recombining of thousands of different mortgages into one
single security. The note servicer, to whom the borrower sent the check, was
usually known, but even they didn't seem to know, or even much care, what
happened to the mortgage money once it was shot out into the vortex.
If you didn't know who ultimately owned the mortgage, you didn't know who to
ask for relief.
Swagel provides little or no real insight on just why the mortgage information
database initiative failed, but I've written about this issue many times, most
recently this past February (see
A scam at the heart of the US, Asia Times Online, February 26, 2009).
The mortgage servicers and owners had enjoyed this cozy little charade they had
going, telling mortgage borrowers threatened with foreclosure that "well, I'd
really like to help you, but you have to talk to the servicers", with then the
servicers saying to the borrowers that "it's all up the mortgage holders" - who
they couldn't find. Not wanting to start a fight with the powerful mortgage
industry in the eighth and final year of an exhausted administration, Paulson
dropped the idea of a mortgage database, and the foreclosures rolled on.
The other track was something, to our misfortune, we've become rather familiar
with these past few months - an effort to get the bad mortgage assets off
banks' balance sheets so the banks could resume normal lending.
"With the lockup in the asset backed commercial paper market leaving assets in
banks' special investment vehicles (SIV's, also known as conduits), officials
in the Treasury Office of Domestic Finance developed the MLEC [Master Liquidity
Enhancement Conduit] plan as a temporary 'bridge' structure to provide
participating institutions with time to reprice and reassess risk"
You can probably guess why MLEC failed - just like Superman with his arch enemy
Lex Luthor, or Sherlock Holmes with Moriarty, this attempt to save the banking
system failed because the banking system was not willing to take reasonable
prices for the bad, soon to be known as "toxic" mortgage securities whose
declining value was spurring the credit market phenomenon we now call
deleveraging.
"Some doubtful banks, however, saw it as something being forced on them;
indeed, a number of economists at investment banks wondered if the supposed
utility of the idea in the first place rested upon a violation of the
Modigliani-Miller theorem (meaning that they did not see the utility). MLEC
never got off the ground."
If you thought that the foundering of US government efforts to rescue the banks
due to the banks' unwillingness to sell the assets cheap began with last
autumn's TARP, Swagel tells us it started over a year earlier, with the failure
of MLEC. The main difference between the failures of MLEC and the ongoing and
quite possibly ultimately failing Public-Private Investment Program of present
Treasury Secretary Timothy Geithner is that solving the problem 18 months ago,
when it was much, much smaller than it is now would have been infinitively
cheaper than it is today or will be tomorrow.
During the rest of 2007 and the early days of 2008, Swagel reports that the
Paulson Treasury tried and failed to come up with a mortgage relief program
that would have effectively assisted threatened homeowners. Every program that
called for the government to pay the tab was effectively stillborn after they
realized that Congress would never foot the bill, and the lenders responded to
every trial balloon that said they should take the first haircut by telling the
government, "No, after you."
Then came the spring, when the US became "Bailout Nation". First it was Bear
Stearns in mid-March. Swagel reports that many in the Treasury were concerned
about the "moral hazard" implications of rescuing Bear from the costs of its
own imprudence and irresponsibility, but "Treasury and the Fed saw little
alternative to rescuing the firm at that time" (or least cushioning its fall),
simply because "the speed of its collapse left markets unprepared". As the year
progressed, this ideology of the expedient immediate necessity would get quite
the workout.
The summer of 2008 was the summer of love for that starstruck couple Fannie Mae
and Freddie Mac, whose boundless devotion to the US market in housing finance
as it chased after the subprime borrowers was their undoing. As the pair's
stock priced dropped in early July, Paulson, according to Swagel, went to
Congress to have it grant "the power to give the GSEs both liquidity and
capital in amounts that would make clear to market participants that the US
government stood behind the obligations of these companies". Yet, amazingly,
the fig leaf that there still was no explicit federal government backing for
the GSEs was maintained. That lasted until September 7, when the continuing
weakness in US housing forced the government to explicitly and formally take
the pair under its wing and place them in receivership.
The furies were unleashed over the next weekend leading into Monday, September
15. US and world stocktraders returned to their desks that day to see Lehman
Brothers dead, Merrill Lynch eaten alive by Bank of America, and insurer AIG
prostrate. It was obvious what these traders were going to do - sell stocks off
hard. From that Monday morning until the middle of Thursday, the US Dow Jones
Industrial Average lost more than 1,000 points, or about 9% of its value.
Short-term money markets froze solid; the Financial Times reported that
Wednesday was the worst day in Britain's money markets since the 1940 German
Blitz during the Battle of Britain.
With the wisdom of the attendant destruction that soon followed, accompanying
the decision to let Lehman Brothers fail comes the most commonly voiced
criticism of the Paulson, era. Swagel says that the markets should not have
been so surprised:
The feeling at Treasury, however, was that Lehman's
management had been given abundant warning that no federal assistance was in
the offing, and market participants were aware of this and had time to prepare.
It was almost as if Lehman management was in a game of chicken and determined
not to swerve.
Lehman may not have swerved, but it was both it
and the markets that crashed. As world stockmarkets went into headlong retreat
that Monday, the unthinkable happened. The Reserve Primary Fund, one of the
oldest money market mutual funds, "broke the buck"; that is, it reported a net
asset value lower than $1, at 97 cents - due to losses of $785 million in
Lehman bonds.
Money market mutual funds pride themselves, indeed it has been their primary
source of appeal, on their rock-solid record of sturdiness and dependability in
protecting depositors' assets. Hitherto, no one had ever lost as much as a
penny of principal in such funds. Without the constant $1 net asset value,
there was no real reason for the money market mutual fund industry to exist,
and without money market mutual funds, the huge short-term commercial paper
market, where companies go to satisfy their short-term borrowing and lending
requirements, could not remain standing, either.
Suddenly, a question mark appeared before just about every corporate asset or
obligation that depended on the ready availability of short-term capital. It's
more than just an old shibboleth to say that markets hate uncertainty - they
really do, and this uncertainty pushed the US economy into the second, far more
perilous and steep chapter of the recession that drove Barack Obama into office
in November.
The Federal Reserve's Asset-Backed Commercial Paper Money Market Mutual Fund
Liquidity Facility (AMLF), along with (although Swagel does not give her
credit) Sheila Barr's FDIC
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