The securitization markets presented a high potential for fraud known as the fraud triangle: need, opportunity, and the ability to rationalize one’s behavior. Many financial professionals have great needs: the need for a larger house in the Hamptons, the need for a large yacht, the need for a rare Patek Philippe watch, the need for a multimillion dollar annual bonus. Lax oversight provides the opportunity. Intelligent people with broken moral compasses—can’t they afford a new ones?— provide the rationalizations.
SEC Chairman Cox testified that the SEC was investigating whether there was unlawful manipulation of Bear Stearns’s stock that led to a run on the firm. Cox did not refer to earlier statements (early 2007 earnings reports) made by CEOs and CFOs that may have propped up stock prices, but he might want to look into it.11 How do we explain the SEC’s poor reaction time to the securitization problems at the investment banks it regulates? Could the SEC’s conflicts of interest have anything to do with it? Former SEC staffers often seem to land very lucrative jobs working for law firms that represent investment banks, working for law firms seeking expert witnesses to defend investment banks, or working for investment banks needing a new general counsel. Some SEC officials often end up affiliated with a huge private equity fund or start a fund of their own with fundraising help from investment banks. I am sure there are many rationalizations for this.
Warren Buffett is among those that felt the Fed action with respect to Bear Stearns was probably necessary: “Just imagine the thousands of counterparties having to undo contracts.”12 I disagree, but I could be wrong, and there is no way to prove this either way since the bailout already occurred. Banks will bid on all or part of a derivatives book. It is a pain in the neck, but it has been done successfully several times in the past. I agreed with Bernanke when he said in testimony: “Normally the market sorts out which companies survive and which fail, and that is as it should be.”13 I wish Bernanke had stuck to that.
Federal chairmen may not want to bite the hand that may feed them in future. Jeremy Grantham wrote in his April newsletter that a Federal Reserve chairman may find that on the retirement lecture circuit “grateful bailees . . . hire you for $300,000 a pop.”14 Charles I. Plosser, president of the Philadelphia Federal Reserve Bank, and Jeffrey M. Lacker, president of the Richmond Federal Reserve Bank, also expressed concern. Plosser said the Fed might be “sowing the seeds of the next crisis.”15 Lacker said the credit hand-out to financiers “might induce greater risk-taking.”16
Congress embraced The Emergency Economic Stabilization Act of 2008, the bailout bill proposed by Paulson and Bernanke, with weak oversight and no requirement for using market prices. William Poole, the retired president of the St. Louis Fed, finds it “appalling” that the Fed is “a backstop for the entire financial system.”17
If the Federal Reserve Bank did not seem like such a pushover, investment banks (and AIG) might have managed their businesses more carefully. Warren pointed out that Wall Street will not worry about the consequences, and I might add that is especially true when an accommodating Fed shelters Wall Street from the consequences of its folly. If Bear Stearns had failed, investment banks, hedge funds and banks might have sat at the table and sorted out their problems.
In September 2008, the Fed let Lehman Brothers (a larger investment bank than Bear Stearns) fail, and helped AIG with a credit line of $85 billion. Were there alternatives? In my view, there were. AIG could have contacted its credit default swap counterparties and asked them for better collateral terms while it was still rated double-A.There is a precedent for this. When ACA, the failed monoline bond insurer (unlike AIG it did not have a diversified business with valuable assets) needed time, its counterparties gave it a six month reprieve. But that was before the Fed bailed out Bear Stearns’s creditors. AIG knew it could run to the Fed, and it initially did, even before it approached JPMorgan Chase and Goldman Sachs for a loan. AIG remained in denial for many months. It worked on a strategic plan instead of acting on its problems, Moral hazard creates opportunity costs, because people with a sense of entitlement tend to get complacent about managing complex risk. Taxpayers can only hope that AIG’s valuable assets are ultimately enough to cover its liabilities, but it never should have become the problem of U.S. taxpayers.We may have to come up with a new slogan—no taxation without regulation.
The Federal Reserve should have saved its fire power, because we have even more serious problems. Warren’s Berkshire Hathaway backs Clayton Homes’ business. In contrast, Fannie Mae and Freddie Mac are highly (and dangerously) leveraged. They had only a 2 percent core capital requirement; banks hold a minimum of 6 percent in “tier one” capital. The burden of both mortgage giants increased in the past two years. In 2006, they accounted for 33 percent of total mortgage backed securities issuance, and as of the summer of 2008 they accounted for 84 percent. Fannie Mae and Freddie Mac have been pressured to help other lenders out of the mortgage mess. Fannie Mae and Freddie Mac guarantee approximately 40-45 percent of the $11.5 trillion U.S. residential mortgage market. As of March 31, 2008, Fannie Mae and Freddie Mac had combined debt of $1.6 trillion and credit obligations of $3.7 trillion.This is a total of $5.3 trillion, roughly the same as U.S. government bonds.18 The U.S. government took over Fannie Mae and Freddie Mac on September 7, 2007, and this is the problem that will probably cost taxpayers the most.The government is in charge of financing most of the U.S. mortgage market, and the mortgage market is still under-regulated. U.S. taxpayers have too many sticky bombs.
The new regulators and the new CEOs do not inspire me with confidence. James Lockhart is the head of the Federal Housing Finance Agency (which will now also oversee the 12 Federal Home Loan Banks) and he was head of the Office of Federal Housing Enterprise Oversight (starting June 15, 2006, just when effective action seemed most needed), the former regulator for Fannie Mae and Freddie Mac. It had over 200 employees and wrote long after-the-fact reports. As Warren put it to CNBC: “You had two of the greatest accounting misstatements in history.You had all kinds of management malfeasance . . . the classic thing was . . . OFHEO wrote a 350-400 page report . . . they blamed [everyone else].”19 This predated Lockhart, but under Lockhart’s watch, things went from bad to conservatorship.
Initially, the mortgage giants charged fees to guarantee prime mortgages (up to a specific size) and borrowers made 20 percent down payments. It was a license to print money, which motivated Warren Buffett to make a large investment in their shares in the first place. It is amazing to me that Fannie, Freddie and OFHEO could screw this up, but overreaching has that effect.That is what motivated Warren to sell the shares in 2000.
In June 2008 (before the government takeover), former St. Louis Federal Reserve President William Poole, said: “Congress ought to recognize [Fannie Mae and Freddie Mac] are insolvent, that it is continuing to allow these firms to exist as bastions of privilege, financed by the taxpayer.”20 In 2006, U.S. regulators imposed limits on lending for Fannie Mae and Freddie Mac after discovering $11.3 billion of accounting errors. On March 1, 2008, regulators lifted those limits. Meanwhile, the FHA, which provides funding for low-income borrowers, is struggling to abolish future no-money-down mortgages.2122
In July 2008,Treasury Secretary Paulson obtained broad authority to purchase unlimited shares of the stock in the companies,23 which could mean unlimited tax dollars—a completely insane and unsound economic policy. The costs are potentially unlimited, as are the opportunities for looting the treasury by gaming the shares.There is no quid pro quo except for a goal of reducing the size of the portfolios over time.Yet there is still little discipline for mortgage brokers and many mortgage lenders. If we want to restore confidence in Fannie Mae and Freddie Mac, we need a two-pronged approach: (1) support the debt (not the shares) issued by Fannie Mae and Freddie Mac; and (2) strongly regulate what backs that debt in the first place. In other words, if taxpayer money is used to help, we must enforce sound lending: 20 percent down payments, verified income, low debt loads and more—t
he traditional standards of sound mortgage lending.There are worse things than renting; for example, piling up crushing debt that forces you into bankruptcy just as the country sinks into stagflation—that is much worse.
The Government Accountability Office (GAO) says we have even greater worries. We are $52.7 trillion in the hole based on our fiscal burdens of social security, Medicare, public debt, and more. That number grows $3 to 4 trillion per year on autopilot. The GAO recommends tough budget controls, comprehensive tax reform, reform of social security, and reform of Medicare. The U.S. needs to generate more revenues through growth. In the face of this, the only advice one can give is don’t retire and keep saving.24 On August 21, 2008, Warren appeared in the documentary on our growing debt burden I.O.U.S.A., a scarier summer thriller than JAWS. Your odds of suffering a shark bite are small, but we are being slowly devoured by our national debt.25
On March 13, 2007, while New Century watched its credit lines disappear and faced allegations of fraud, U.S. regulators complained that the United States investment banks lost business to London. Sarbanes-Oxley requirements became the scapegoat. Hank Paulson assembled a panel at Washington’s Georgetown University. Paulson invited several notables in the financial markets, and Mr. Buffett went to Washington.26
John Thain, then head of the New York Stock Exchange (later the CEO of Merrill Lynch that arranged its sale), said that only two of 25 IPOs in 2006 were made in the United States. The implication seemed to be that Sarbanes-Oxley, inspired by Enron, Worldcom, and other corporate malfeasance, hampers business. The collapse of Enron and WorldCom led to billions of dollars in losses for investors and cost thousands of people their jobs. Adelphia’s former CEO, John Rigas, and his son, Timothy Rigas, the chief financial officer, were found guilty of fraud and conspiracy after hiding $2.3 billion in debt. On June 17, 2005,Tyco’s L. Dennis Kozlowski and Mark Swartz, charged with stealing $600 million in unapproved compensation and illicit share deals, were found guilty of criminal counts of securities fraud, eight counts of falsifying business records, grand larceny and conspiracy. Ex-waitress Karen Kozlowski filed for divorce in August 2006 and sought to keep booty paid with loans that Tyco later “forgave,” including some of hundreds of thousands of dollars in Harry Winston jewelry. She may be disappointed. Businesses will fund business trips, but you might have to reimburse the company if it funds your ego trips.272829
Warren felt that after such astonishing corporate malfeasance, it is a “question of restoring trust.” He added “American business is working pretty darned well.” Although compliance with Sarbanes-Oxley cost Berkshire Hathaway tens of millions, he said it might do some good if it restores investors’ confidence: “There are worse things than Sarbanes-Oxley.”30 Three years prior to Paulson’s meeting, Warren attended a conference at which Mikhail Khodorkovsky, the former CEO and owner of AOA Yukos Oil Co., asked him if it would be dangerous to bring an IPO in the United States. Three or four months later Khodorkovsky was imprisoned in Siberia.Yukos went belly-up in 2006 and had back-tax claims exceeding $30 billion.Yukos’s assets were subsequently bought by Russia’s largest oil company, AOA Rosneft at bankruptcy auction.31 Sarbanes-Oxley requirements seemed to discourage Khodorkovsky from making an initial public offering of Yukos’s stock in the United States.We dodged a bullet.
Jeffrey Immelt, chairman and CEO of General Electric Co., also attended Paulson’s conference. He complained that regulatory requirements are “just too gosh-darn complex.”32 As too gosh-darn complex as the subprime-backed investments that later cost GE $300 to $400 million of dollars worth of write-downs?33
In contrast, Warren noted that some of Sarbanes-Oxley requirements promoted transparency, and he eagerly reads financial reports: “like a teenager reading Playboy.”34 Readers of financial reports and Playboy agree that more transparency is desirable.
Part of the reason we are losing business to London may be that quite a few international investors are concerned about structured financial products they bought from U.S. investment banks. Loans were made to people who would not be able to pay them back, ratings are flawed, and securitization technology is suspect. We are losing business because we were found out. Europeans in particular feel that smart Americans abused securitization technology to fool a lot of people in the short run. In a letter to the Financial Times on March 19, 2007, I wrote:
Wall Street’s former standard: “Your word is your bond, did not mean “Your spin is your shield.” . . . [I]n areas in which we are lightly regulated, our words are unworthy.35
Until recently, I opposed hedge fund regulation. Eric Mindich (formerly of Goldman Sachs) now heads Eton Park Capital Management. When Mindich was assigned to head the President’s Working Group Asset Managers Project, I volunteered my perspective: “I am a laissez faire capitalist, and do not believe in protecting consenting adults from making informed decisions, even if that decision is to make a blind bet.” That was in September 2007, but my point of view is changed, since U.S. taxpayers bail out hedge funds creditors.
The hedge fund business is approximately $1.9 trillion in size, and 87 percent of the money is controlled by fewer than 10 percent of the hedge funds.The larger hedge funds have a lot of clout. Large hedge funds act as if they are investment banks. Often they accumulate large trades—taking the other side of an investment bank’s trade—then call up the investment bank and ask them if they would like to negotiate to close out the transaction. In other words, for some types of transactions a hedge fund is the other side of an illiquid market.
Furthermore, when investment banks bail out hedge funds (and structured investment vehicles), these entities are not truly off balance sheet. For example, Citigroup took around $9 billion of assets on balance sheet from Old Lane Partners, the former hedge fund of its CEO, Vikram Pandit.36 Bear Stearns bailed out creditors of two of BSAM’s hedge funds, and Bear Stearns was subsequently purchased by JPMorgan Chase with help from the Fed. Since the Federal Reserve Bank supplies liquidity to the banking system, and since the SEC regulates investment banks, hedge funds should be regulated.
Bank problems could get even worse. Banks moved assets off their balance sheet using structured finance. They set up off balance sheet entities that owned the assets and issued debt. Now the banks may have to take $5 trillion in assets back on balance sheet as if they had never been moved.37 Although the vehicles currently pay for themselves (their assets meet their debt payments), if the assets’ quality falls into doubt, banks might have to bail them out (as Bear Stearns bailed out the creditors in the hedge funds).The banks would have to borrow more money from the Fed. Even if that does not happen, banks’ debt to equity ratios will increase, and banks will be less willing to lend you money.
We have too many ineffective regulators: the OCC, Fed, OTC, FHFA, SEC, FDIC, and more. Watching the regulatory system is like watching bad doubles tennis players. No one hits the ball thinking the other guy will get it. Investment banks are not suffering from too much regulation.The global capital markets are suffering from too little competent regulation where it counts most.
The Fed, Congress, the Treasury, and the Bush administration wanted you to believe they have solved the “regulatory problems.” On March 31, 2008, a couple of weeks after the Bear Stearns deal, Treasury Secretary Hank Paulson rolled out the “Blueprint for a Modernized Financial Regulatory Structure.” The draft of this report was prepared in November 2006, when the Treasury alleged excessive regulation caused the U.S. financial markets to lose its competitive edge to London in the global financial markets. In other words, it called for less regulation, not more.38
At its core, the mortgage lending crisis is no more sophisticated than a schoolyard swindle, and the SEC is the principal. Economists and pundits unhelpfully—and conveniently—focused on the Federal Reserve Bank and retired Chairman Alan Greenspan. Others blame the rating agencies.Yet neither the Federal Reserve Bank nor the rating agencies regulate the securities industry. That job belongs to the SEC. The SEC has broad au
thority over banks, too. The Office of the Comptroller, the OCC, examines the risk management of the capital markets areas of banks. The Federal Reserve Bank primarily looks at banks at the holding company level.The SEC has broader authority than either the OCC or the Fed for publicly traded companies. It is deceptive securitization practices at the root of the mortgage bubble, and the SEC had the authority to stop Hurricane Ponzi. Instead, it slumbered.
Wall Street acts fast, and its regulators move at glacial speed. In other words, the existing regulation—even if it demonstrated the will to be proactive, which it did not—is too slow.The system is doomed to repeat its failures, because as Benjamin Graham observed, when things are going well in the financial markets, there is “a strong temptation toward imprudent action.”39
As long as Wall Street enhances revenues with leverage to prop up kingly bonuses, as long as there are few personal consequences for CEOs (and board members and other top executives) for shoddy risk management, as long as CEOs are allowed to walk away with millions, nothing will change. The fact that shareholders are wiped out is no deterrent, and moral hazard will live on. I see nothing that will change that in future. In fact, just the opposite. We have handed out hundreds of billions of dollars in taxpayer dollars and have put hundreds of billions more at risk without demanding effective conditions.
Our bailout bills are mounting. The treasury has extended more “temporary” credit lines to the 12 Federal Home Loan Banks, and the government has an additional $90 billion in exposure to the FHA.A new housing bill created a $4 billion fund for local governments to buy foreclosed homes, a $7,500 tax break for first-time home buyers, and a $300 billion insurance fund for refinanced mortgages (but no clear way on how to control the risk of the new mortgages). As of July, there is an 18 month line of credit for Fannie and Freddie to borrow from the Fed, and Bazooka Hank has authority to purchase shares. The FDIC has taken on $39.3 billion of failed bank assets (as of September 2008, and there is more to come). The Fed created various special financing programs amounting to hundreds of billions of dollars. The Fed took $29 billion (after using up JPMorgan’s $1 billion on the original $30 billion) of exposure to Bear Stearns’s assets and gave an $85 billion credit line to AIG. If that were not alarming enough, the Fed relaxed its borrowing standards to allow borrowers to present equities as collateral. Benjamin Graham cautioned that if you have common stocks you “must expect to see them fluctuate in value.”40 You now means the U.S. taxpayer.
Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street Page 24
