Neighborhood Transformation

Neighborhood Transformation
October 6, 2008

How "Credit Default Swaps" enriched Wall Street insiders and sparked the meltdow

By Tom Zuniga
DSG Community Marketing Services LLC
Miami, Florida

I thought I knew numbers.  My business calculator, however, cannot make sense out of the numbers that are presented to us about the current economic crisis.  Just how bad is the problem?  Consider the following:
  • Congress has expanded FHA authority by $300 billion to allow people with adjustable rate mortgages to refinance their loans into fixed rate, government guaranteed, government insured loans.  Most banks are cooperating in this effort by reducing loan amounts to accommodate the refinancing
  • Congress has authorized $3.9 billion in funds under the Housing and Economic Recovery Act (HERA) and HUD has allocated the funds to States and Local governments to purchase foreclosed properties that threaten neighborhood stability.  (As a practitioner familiar with HUD program history, and now having read the HERA program--this is the most flexible block grant initiative from the fed in recent memory.  More on HERA in my next memo!)
  • Congress has now authorized $700 billion for Treasury to buy bad "paper" resulting from bad mortgage loans, mortgage-backed securities pools; defaulted car loans, failed credit default swaps, and God knows what else gone bad is eligible that smart bankers invested in that now need to be rescued
The numbers indicate a more serious problem than we were led to believe.  So for graduates of DSG's community development training programs, here is a little perspective:
 
Whatever the political posturing regarding the current rescue plan, a plan needs to be passed and despite the pork laden Senate bill, the House will follow.  Credit markets are frozen and banks are going bust every day. This is not totally because of "toxic" mortgages. This has a lot to do with FASB 157, also known as "mark to market".

Each day lenders must mark their assets to the marketplace. It's like you having to appraise your home everyday and if your neighbor was under duress because they got very ill, divorced, lost their job and was forced to sell their home quickly they may have sold it super cheap. Now, does that mean your house is worth that super cheap price? Clearly not. Why? Because you are not under duress. You have the time to sell your home and get a more normal price, which more accurately reflects true market conditions. But "mark to market" does not allow for this, which creates a vicious cycle.

Why is this so bad? Because as lenders mark down their assets, the amount that they have loaned previously becomes much riskier in relation to their assets. For example, say a bank has $1 million in assets and say they have $15 million in loans outstanding. Their ratio is an acceptable 15 to 1. But should they take a paper write down of $500 thousand due to "mark to market" requirements, their ratio suddenly changes to 30 to 1. This is because their assets are now only $500 thousand after taking the paper loss, while their loans outstanding are $15 million. And at 30 to 1 this bank is viewed as a risky investment. So the stock price starts to get hit, it becomes harder to borrow, and most importantly harder to make money. The bank is then forced to sell some of its loans to reduce its ratio...at cheap prices. And this makes the vicious cycle continue.

And a quick look at the holdings of these loans show that 95% are problem free. Additionally, the Credit Default Swaps (CDS) that are used with the pools of mortgages are relatively safe. But this requires a bit of understanding. You see, when a pool of mortgage loans is put together, it isn't just A paper or B paper etc….it's everything. It's got some A paper, B paper, C paper…and even what looks like toilet paper. An "A" investor buys the whole pool but because they are an "A" investor their safety is greater because they can avoid the first 20% (an example) of defaults. So they own the whole pool but are sheltered from the first batch of defaults, and for this they get the lowest rate of return. As you can figure from here the more risk investors want to take, the higher the return. So the investments are relatively safe, but the accounting rules currently place undue pressure on the banking institutions.

Now add to all this, the opportunistic "shorting" done on the financial stocks, much of it illegal because those shorts did not legitimately borrow shares (called naked shorting), and you exacerbate this whole problem. Thank goodness for the recent temporary ban on shorting in the financial sector. As for the plan,  the government is the only one who can step in to do this. And they have to do this. And they will do this. The nauseating political posturing from both sides is just part of the process.

This is not easy to understand for the general public. In fact most politicians don't get this either. That's why it is a difficult yet critical bill for them to vote on.
Once this is done it will take some time but the markets will stabilize. As for the real estate and mortgage industries, it will take a bit of time but we will make it through this.  Rates will remain attractive and the influx of credit availability will help the housing market gradually improve. This ultimately will be the medicine needed to improve the situation overall.
 
A more urgent problem is the chorus of legislators who are blaming the economic crisis on CRA lending and the promotion of homeownership to low income families by the federal government.  "The bankers were pushed by government to lend money to poor people who could not afford them".
 
I am asking for help from John Talmage and Social Compact to fact check this charge based on available data.  What are we to make of this?
 
As always – please keep in touch, especially during these volatile times. I am here to help you in any way that I can.

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Tom Zuniga, Managing Director
DSG Community Marketing Services LLC
Miami, Florida
Mobile: (305) 305-1468
E-Mail: DSGTomZuniga@gmail.com