Bernanke's Wall Street Welfare

I've spent a number of years working as a lawyer in the general area of housing finance, so I believe that I understand a bit about what's going on with the recent federal actions. And I don't like it. Hundreds of billions of our tax dollars have been put at risk by the recent actions of the Federal Reserve Bank under Ben Bernanke's leadership, and nobody seems to care how the decision is justified.

Part of the reason, I believe, that nobody is challenging this giant theft of our national treasury is that very few people aside from those who directly benefit from it actually understand it. So in the interest of doing my small part to spread the word, here's my take on it...

The origins of this mess can be found in the ability of Wall Street to package mortgages and the risks associated with them in a variety of ways to meet the needs of every kind of investor. Traditionally, if you wanted to buy a house, you went to your local bank and, if you were credit-worthy, and had a sufficient down payment given the price of the house (typically 20%), they would give you the loan and they would receive the payments.

In or around the 1990's or so, banks discovered that they could package these loans and sell them to investors from around the world, thereby raising more money for additional rounds of lending. As that market got more sophisticated, they invented various forms of ratings and insurance and default contracts and other fancy bells and whistles that, in theory, allowed the risk to be allocated exactly to those who could most afford to bear it.

The system worked pretty well, actually, and with the stock market doldrums that set in after the dot-com crash, a lot of money began to flow into real estate. With these sophisticated mechanisms in place, there was plenty of money available for lending. In fact, the appetite for these packaged loans became so intense that the credit-worthiness of the buyer was not that important so long as the loan amount was ever so slightly below the market value of the house, and, more importantly, so long as prices were rising fast enough such that any financial difficulty encountered by the buyer could be immediately solved by a refinance with a cash out of accrued equity.

As housing prices continued to rise at an incredible rate, the loan packages became a huge cash cow for Wall Street, with investment houses buying and selling them by the billions, and the total amounts actually went into the trillions when you added in all of the related exotic financial instruments also being sold that were backed ultimately by these loans and the wonderful little houses on which they were issued.

Of course, like all bubbles, the whole apparatus worked great only because prices were rising. I don't have as much personal knowledge of this as others, but based on my own experience, I'm willing to bet that there was a lot of laziness built into the system during the frenzy. People created a lot of paperwork covering all kinds of "what if" scenarios that would never come to pass in 99% of the cases because the ultimate insurance policy was in place: rising prices and easy refinancing. The sloppiness gets papered over when the worst case scenarios never come to pass.

Well, at some point you get into the "froth" of the bubble. Loans were being made to anybody with a pulse, no down payment, no verified income, houses being appraised for way above prices that could ever be sustained across the entire market (as opposed to the small percentage of houses that sell in any one given year). A substantial number of "sub-prime" borrowers just couldn't make those payments, and they started to default.

When that news hit Wall Street, everyone knew that the "jig was up" and the only question was who was going to get caught holding the bag. Suddenly, investors were no longer interested in buying these loans, and those holding them could not sell them. This ended the availability of sub-prime loans at the retail level, which ended the housing boom. With no loans available, prices started to drop.

For those "holding the bag", the question quickly became: what is that bag really worth? How many people would walk away from their loans, having put no money down in the first place? What would the houses actually be worth if they had to be foreclosed on? Unfortunately, these questions remain more or less unanswerable because until the market hits bottom, there's no way to predict with any degree of uncertainty the answer to those kinds of questions.

Therefore, everyone just kinds of stands still, at best trying to prevent the infection from spreading to the better classes of mortgages. Unfortunately, it has because (1) it's not always clear that a given package consists exclusively of one type or the other (the rating agencies themselves have come under fire for failing to do their job); and (2) with housing prices falling even a fairly credit-worthy individual may still decide that making payments that are three times the cost of rent when the price of the house is falling and he/she has no equity is not a smart thing to do.

And thus, we arrive at Bear Stearns, March 2008. Bear was a big loser in the game of who was left holding the bag, having gone into these mortgages in a bigger way than most of the others and, apparently, being late in the game in terms of heading for the exits. They were vulnerable, and on Wall Street, there's no pity, only opportunity for advantage.

By way of analogy, I visited an aquarium recently and there was an enclosed exhibit of Alaskan King Crabs. For whatever reason, I happened to witness a huge crab attack a "vulnerable" crab and literally rip apart its shell, dig into it with its huge claws and eat it alive, while three or four other crabs watched from the sidelines. It was really ugly, and the funny thing was that ten minutes later after the victim had been removed, we came back to see that each of the remaining crabs was occupying the corners of the exhibit with their backs to the wall, eyeing the others.

This is what happened during the week leading up to and including Sunday afternoon on Wall Street. Bear Stearns showed some weakness, and the rest of Wall Street got the hell away from them as quickly as possible, while the biggest crab in the cage (JP Morgan) went in for the kill.

Now that is all fine and dandy, American capitalism at its dog-eat-dog best. And if that was the end of the story, I could go on with my life without feeling the need to write this diary. But no, here comes Mr. Bernanke with hundreds of billions of our hard-earned dollars at his disposal. Actually, specifically, he apparently has approximately $800 billion dollars in Treasury notes that he can apply to this crisis (beyond that and we're getting into federal bankruptcy territory). Treasury notes, are, if you don't already know, almost just like cash, because everyone on this planet knows that, no matter what else happens, all of us G-d fearing Americans will be paying our federal taxes in full come hell or high water.

For at least six months, Bernanke had been trotting out the usual strategy for these kinds of situations, which is to lower interest rates just to keep the money flowing. This, of course, lowers the value of the dollar, which is dropping anyways, so no we won't be taking many exotic vacations anytime soon, or buying foreign cars, or even Swiss chocolate I suppose. It sucks that he's going to kill the dollar in order to keep these banks out of default, but I could live with it. I'm happy to stay and buy local. I could just chalk that up to one more consequence of the colossal FUBAR that is the Bush Administration.

Unfortunately for Bernanke, however, lowering interest rates hasn't done the trick. If the loans on the books are worthless, who wants to start making new ones, even if the terms are favorable? So now, he has gone to some new, more extreme, strategies and it is these that I really have an issue with. Here's what he's done just in the past two weeks:

1. He offered to trade $200 billion in Federal Treasury Notes for God knows how much in sub-prime loans (and how could you know being that there's no market for them?). So the ultimate answer to "who's going to be holding the bag" has found an answer and it is of course, the taxpayer. We the taxpayers will not collect much on these worthless loans, but we will make good on our obligations to these same bankers in paying the Treasury Notes. This is truly a case where someone else has a huge party, and leave us to clean up the mess and pay the caterers.

2. He gave a $30 billion loan guarantee to JP Morgan in order to entice it to buy Bear Stearns. So, JP Morgan takes over all of Bear Stearns assets and obligations and to the extent that people default on moneys that were owed to them, i.e. subprime borrowers, so long as it doesn't amount to more than $30 billion, we the tax payers will take care of it. Again, the "holding the bag" question is answered with the taxpayer.

3. He's opened up the Federal Reserves's "Discount Lending Window" to investment banks, so that these private fiefdom's of the very rich can now access our tax monies at the best possible rate -- the rate that for the last 70 years has been available only to commercial banks...you know the kind that you or me might actually be able to do business with. Tens of billions of dollars were so accessed in the first week.

I'd just like to hear a good argument in support of this. I suspect that the argument is that the cost to all of "us" collectively of the failure of a major investment bank, or of radically-discounted sales of these loan packages, or of investment banks lacking the liquidity to meet their obligations, would be far more than the $230 billion and counting that we're putting ourselves on the hook for in order to prevent that from happening. But I've not seen Mr. Bernanke make any such argument. Or anyone else.

For myself, I don't buy it. This is a pretty exotic little world here, and a market which as I mentioned above didn't even exist for the most part not that long ago. Was the market for mortgages so bad in 1990 that we can't afford to return to that?

And morally, it just burns me up to think that Bush gave these same guys not one but two trillion dollar tax cuts just a few years ago, then they made billions pumping up this market and luring millions into loans that they couldn't afford based on radically inflated house values (incidentally pricing out all but the most foolhardy), and now that the inexorable fall comes, well, the taxpayer must pay or the nation will crumble.

What would I do instead? I'd probably leave Wall Street to its own devices, and instead set up a federal program to buy the foreclosed houses and turn them over to nonprofit organizations for resale and/or use as affordable housing. The originators of the loans deserve to lose their money, and the borrowers deserve to lose their homes. But the rest of us deserve to be insulated from suffering the negative effects of having lots of vacant homes littering our neighborhoods, and the program I've described would accomplish that.