MONEY MATTER

By Gene Coppa

As everyone reading this article has likely noticed, the financial markets of the world have been in upheaval over the last several months. This upheaval has been caused by a whole series of events that have come together to bring down an immense, global financial system, in which companies value the risk of each and every investment.

In the midst of this greatest economic event of our lifetime to date, I think it is most important in this column for me to try to give you some background about what is going on with the Emergency Economic Recovery Act and the upheaval in the financial markets.

So how did we end up in the current “financial crisis?” The reality is, there are lots of theories about this. So, I’m going to give you mine. The difficulty with telling a story about what has happened, is defining what our starting point is.

So, for now, I am going to define our starting point in the 1990s with a “financial derivative” product called a “credit default swap” (CDS). CDS is essentially an insurance contract between any two parties, usually corporations, that says that for a certain fee per year, the insurer, for lack of a better word, agrees to pay the insured value if the insured security reaches a certain level of default.

This is a difficult theory, so let’s take an example. Bank A lends out a series of loans that total $1 billion (MBS 1). In order to insure that the default rate of the loans in MBS 1 stays below 10 percent of the total loans, Bank A buys from Hedge Fund A a CDS. Bank A pays Hedge Fund A $200,000 per year for Hedge Fund A to insure that if the default rate of MBS 1 exceeds 10 percent, Hedge Fund A will pay Bank A $1 billion.

To take an analogy from the real world, many of us would never take part in the activities we do if we did not have medical insurance. For instance, if you knew you would have to pay the full amount of the medical bills for going to the emergency room if you got hurt playing softball, how many of us would keep playing softball, or even start playing softball. In essence, insurance encourages us to do things we wouldn’t otherwise do.

The same was true for banks: When CDSs started, they were essentially insuring typical prime mortgages with 80 percent or less loan to value (LTV) ratio with credit worthy borrowers. But as lenders were able to get insured against loss by buying CDSs, the risks they were willing to take with higher LTVs and borrowers with lower credit scores also increased. Along came “subprime lending.”

At the same time, lenders began packaging loans together and selling them off to the open market as a mortgage backed security (MBS). Banks did this because of two reasons:

(1) Banks may lend $10 for every $1 they hold in deposits. By moving the loans off their books, they were able to lend that $10 all over again; and

(2) Even after moving the loans off their books, they could still make money by “servicing” the loans (continuing to receive payments and manage the loans for the new owners of the loans in exchange for an ongoing fee).

With subprime lending available and lenders willing to lend more and more money, more borrowers were able to buy houses, driving the housing prices artificially high. I say artificially, because the homeownership rate over the prior 60 years ranged between approximately 65 and 68 percent. Upon introduction of these new types of loans, homeownership rates skyrocketed to about 75 percent.

That swing artificially inflated prices of houses. However, it was only artificial if home prices began declining. Unfortunately, they always do, eventually.

When home prices began declining, the rate of defaults began increasing. As the rate of default began increasing, the banks, who still held a lot of the mortgages on their books, began triggering the default provisions of the CDSs. The only problem was that the Hedge Funds that sold the banks the insurance, never kept sufficient money on hand to pay off in case of default. So, it was like you going to the hospital after you broke your leg playing softball, and then being told that your insurance company didn’t have the money to pay the bill.

That being said, the rate of default, even for the worst performing loans, was only 20 percent. And for typical prime loans, which banks still held a lot of, the default rate was substantially less; usually around the 6 percent range. That means that 80 percent of the worst performing loans were still performing! And 94 percent of the normal loans were performing!!!

So what really happened? In order to fully explain the rest of the story, I have to introduce an accounting rule called “Mark to Market.” The Mark to Market rule was used in widespread fashion after the Enron debacle to ensure that corporations were being truthful to shareholders about the current value of the assets held by the corporation.

To ensure this truthfulness, the Mark to Market rule required all companies, banks and other publicly accounted entities to revalue their holdings as often as every day. This revaluing required the corporation to determine the fair market value of an asset.

In the case of MBSs and another financial instrument called a Collateralized Debt Obligation (CDO) which were owned by a lot of banks and other investors, the market began to dry up very quickly for resale of these instruments. When the market dried up, so did the Mark to Market value for the balance sheet of the owner.

Here’s an example of how this works: Let’s remember that a bank may lend, but cannot lend more than, $10 for every $1 it has in assets. Bank A owns $1 billion of CDOs for loans in a loan pool. That $1 billion allows the bank to lend $10 billion.

Now, during the credit crisis, the market for that CDO completely dried up, meaning that no one would buy it. Under the Mark to Market rule, Bank A has to write down the value of its assets by $1 billion even though, at worst, that $1 billion was still performing at 80 percent, or $800 million. When that $1 billion disappears from Bank A’s balance sheet, it must quickly come up with $1 billion in assets (usually by going after deposits from consumers in the form of CDs) to cover the $10 billion they already lent out. If Bank A does not come up with those assets, it may be taken over by the FDIC as insolvent.

And that is exactly what happened to many institutions. In writing down the value of their assets based on the Mark to Market rule, they were unable to come up with the capital to stay solvent, and unable to continue to loan additional money.

Fast forward now to the Emergency Economic Recovery Act. The Treasury Department, in an effort to shore up the balance sheets of banks and other financial institutions, proposed to purchase CDOs and MBSs from those institutions through a $700 billion fund set up by Congress.

By offering to buy the CDOs and MBSs, the Treasury Department would create a market for the securities, allowing the financial institutions to revalue their current holdings based on their market value. By doing this, financial institutions would not be subject to risk of closing and may be able to begin lending again as their assets became sufficient to overtake their outstanding loan balances.

However, during the last couple of weeks, the Treasury Department has changed the way it is doing things and, instead is making direct cash infusions to the financial institutions to bring their asset base back. For a real example, the Treasury Department is buying the preferred stock of a number of major banks in the U.S. to immediately bring up the value of their assets by giving the bank cash for those shares of preferred stock.

When the Treasury Department does this, the financial institutions can then begin lending again, and the “credit freeze” should eventually begin to thaw.

In the end, the only thing we know for sure is that the financial landscape will be different tomorrow than it is today. With unemployment increasing, home prices still declining in many areas, and the economy having difficulty, it is not going to be easy for anyone over the next few months or even years.

But, in the end, the moves the government is taking today are exactly what is necessary to insure confidence in our nation’s financial institutions and resume some of the “financial truths” that we have always believed in. We will survive, but the pain will be very harsh for many of us.

ABOUT THE AUTHOR: Gene Coppa is the CEO of The Financial Firm, Inc., a real estate financing company. For information on this article, or with other questions, contact Coppa at 1-800-390-0809, or (805) 654-0809, or e-mail: GCoppa@tffmtg.com, or log onto the website at www.tffmtg.com.

 

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