Tuesday, February 19, 2008

Rise of the Bezzle
Jeff Sanford
Canadian Business Online, February 18, 2008

We’ve still got several weeks of winter yet. But at least we’re past January 24th, the day one scientist has calculated to be the “worst day of the year.” Oddly enough, it’s a day that fell square in the middle of the recent market meltdown.

Are we humans really so objectively predictable that big market movements like those of the past month can be explained by simple cause and effect? Aren’t markets supposed to be products of rational decision-making on the part of the individuals who participate in them? And isn’t that kind of rational decision making supposed to preclude irrational, herd behaviour on the part of market participants? You would think so. But the Great Housing Bubble of this decade — now fading rapidly into history — is a perfect reminder of just how irrational and unthinking markets can be.

The root of the current market volatility can be traced to any number of incidents. But let’s go right back to the beginning, back to the ’90s when Republican party dissatisfaction with the big government-sponsored mortgage firms like Freddie Mac and Fannie Mae (created in the ’60s to extend credit to lower income U.S. home buyers) saw those businesses reigned in somewhat in terms of their lending ability. “When accounting problems showed up at those institutions they were put in the doghouse and the Republicans said, ‘Let’s see what the banks can do,’” says Stephen Jarislowsky, the moral voice of Canadian capital markets. “It was like letting the 47 thieves of Ali baba out.”

What followed was an orgy of mortgage lending by the banks that resulted in the evolution of ever-looser credit standards, a temporary home price bubble and now a corresponding revision to the mean (a bust) that is threatening to take down the North American economy.

This latest crisis is just one in a long history of periodic speculative bubbles and resulting panics: The tech bubble of 2000; the Asian Crisis in ’97; the market crash of ’87, and the S&L crisis of the ’80s. All have come and gone with remarkable consistency. “They come every five or seven years like clockwork,” says Jarislowsky. Is there some kind of collective programming in the human species that trumps our individual capacity for reason? “I’m always amazed at how fast people forget the last bust,” says Jarislowsky.

One of the great minds of economic thinking, John Kenneth Galbraith, long ago pointed out an interesting bit of herd behaviour that seems to reoccur in every bubble. According to Galbraith, whenever we got to the end of a bubble, the Bezzle — a term for, basically, corruption — will always rise. You can set your watch to it. As a bubble inflates the early euphoria of “new money” begins to fall away and as the end comes into sight the players closest to the action get agitated and begin doing whatever they can to grab whatever they can off the table before it all falls apart. And so it was with the recent U.S. housing bubble.

The housing boom rose on the back of securitization: the idea that banks would write mortgages and then bundle them up into securities they sold to other financial firms, to get the loans off their own books. This was different than in cycles past when banks held on to those loans, which created an interest in making sure the loan was viable. In this round, with the loans off of the books of the originating institutions, the accent was on writing the loan and taking out the one-time signing fee. The interests of the mortgage brokers changed. The long-term viability of the loan was no longer as important as the sign-up fee. Those writing the loans didn’t care whether they could be paid off since they were being packaged into securities too complex for almost anyone to understand.

As one bank and then another realized how well this model was working (at least in the short term), every other bank had to jump in or else they would fall behind the competition. The quarterly focus of the banks pulled more players into the game and the whole cycle began to spin faster. As more people poured in, more people became desperate to make a buck, and the Bezzle began to rise.

By 2006 the terms on mortgages had loosened to the point that fee-grabbing mortgage brokers were signing people up to mortgages that didn’t require documentation or even much in the way of I.D. Who loans money for 20 years to people they don’t know and who can’t prove they can pay you back? Reprehensible people who just want to make a buck.

Stephen Jarislowsky has nothing but contempt for the people who took part in the feeding frenzy. “It’s greedy compensation schemes and short-term thinking. I asked a bank president, ‘Who thought this was a good idea?’ They never thought about it. Everyone around them was doing it. Not many understood it and so when one guy seemed to understand it, everyone else thought it must be OK,” says Jarislowsky. Of course the regulators could have stepped in at any time. “They could have said, ‘No, you can’t lend to people with no money,’” says Jarislowsky. But they didn’t, and the devolution in lending terms increased as fee-grabbers began to take whatever they could off the table as the Bezzle began its march to the peak.

If there is one person more responsible for this mess than any other, it’s Angelo Mozilo, the CEO of Countrywide Financial, and one of America’s best-paid executives. His company emerged as the leading practitioner of the kind of sub-prime lending that led to these problems. U.S. Senator Charles Schumer recently singled out Countrywide as most representative of the “greed … motivated widespread, irresponsible lending that contributed to what could have been the largest home foreclosure crisis in our country.”

Schumer went on to accuse Countrywide of giving sales staff incentives to market the most expensive mortgage loans for the company “and its partners.” According to Schumer, “We have learned that Countrywide’s promise to get borrowers the ‘best possible loan’ have been nothing more than a commitment to squeeze every dollar possible from homeowners. In fact, Countrywide’s lending business model prioritizes fees and commissions over the financial viability of the loans.”

Thank you, Mr. Schumer, for the confirmation. Fully one-quarter of Countrywide’s mortgages have now gone under, which should be considered criminal. Any respectable loan office can tell you there are commonly accepted business practices that can be easily applied to a loan portfolio that would allow you to avoid a default rate like that.

Of course, Mozilo says it’s not his fault. He’s been quoted as saying the real causes of the mortgage crisis are interest rate hikes, lower real estate prices, and the disturbingly brazen notion that “tightened regulations around interest-only mortgages” caused the collapse. If that doesn’t make you want to push a man under a bus, what does?

But let’s not forget those who Schumer called “the partners,” the mainstream institutions who got in bed with Countrywide to package up these increasingly dodgy sub-prime loans into the now infamous bundled mortgage securities that were sold to pension funds around the world and stuffed into the retirement funds of many a retail investor.

A suit filed by the New York State comptroller Thomas DiNapoli and city comptroller William Thompson Jr. (the individuals responsible for overseeing government pension funds that invested in Countrywide securities), names RBC Capital Markets Corp., RBC Dominion Securities Inc., RBC Dain Rauscher Inc., Scotia Capital Inc. and TD Securities Inc. as just some of the companies that partnered with Countrywide in the alleged fleecing of America’s poor. “Countrywide’s underwriters had a duty to investigate whether Countrywide was acting honestly,” DiNapoli was quoted as saying about the suit.

How bad was it? There are all kinds of heartbreaking stories emerging about financially unsophisticated people who were doing just fine in the mortgage they were in but were convinced by mortgage originators to sign a Countrywide mortgage with a low “introductory” interest rate. These poor and financially illiterate people signed on thinking their mortgage payments would drop, which they did, for a few months. When the introductory rate ran out, or the adjustable rate mortgage started adjusting (a feature many people signing up were not made aware of), these people found themselves paying far more than what they otherwise would have. Real people lost their homes, while the mortgage broker grabbed the fee and ran.

I’ve always argued free-market capitalism is the best way to run a society. Granting people economic freedom allows distributed economic processing to take place among the entire population. This is a better economic architecture than a centrally planned (communist) system where economic decision making is concentrated at one point, and the processing of economic decision making slows to a crawl. But the freedom that has translated into our current wealth comes with a cost, as we’ve just seen. I’ll continue to argue that capitalism is the least worst system. It’s all we’ve got. But incidents like these where capitalism goes out of its way to give itself a bad name, make you wonder. “No one is accountable. No one takes responsibility,” says Jarislowsky. “You can follow the trail but you can’t get to anyone. They just say, ‘Oh, didn’t you read the footnote on page 42?’”

Former employees of Countrywide have filed a class action lawsuit against Countrywide accusing it of being, basically, a financial “sweat shop.” But the kicker on this story is that Mozilo could ride off with a compensation package said to be close to $115 million (and would include free use of the company jet and paid-up country club fees until 2011). Apparently, this is the price of a free market. As for the rest of us, let’s note a couple of lessons here before we let this sordid event pass into history. Lesson one: Altering time-tested institutional-interest structures (such as holding a loan over its life, as opposed to moving it off the books through securitization) always has unintended consequences that are likely going to come back and haunt you. And lesson two: if you want to know when the bubble is reaching a peak, keep your eye on the Bezzle — it always rises.