Before The Cure, The Diagnosis: New Ideas About The Global Financial Crisis

By Guest Author Linda Allen

There has been a lot written about our current financial dilemma. Distinguished professionals have blamed the housing market, the dollar, accounting rules, human nature (i.e., greed), regulation/deregulation, past monetary policy – the list goes on, as does the list of culprits to blame. These pundits also typically have a pet project or magic bullet they promise will solve the problem. Unfortunately, there are no magic bullets – every time the market appears to stabilize (for example during the summer of 2008), there is a new disaster waiting in the wings (Lehman’s bankruptcy and the “weekend that Wall Street died”). I don’t promise any magic solutions. Instead, the solution will take hard work and time. But we will not even be able to get to work until we first diagnose the root cause of the current devastation in global financial markets.

It is usually at the stabilization stage of a financial crisis that the vulture funds, sovereign wealth funds and workout specialists begin to hunt for bargains to purchase securities depressed prices. That is, since financial markets often overshoot during crises and decline more than is warranted by fundamentals, vulture investors usually seek to buy assets at fire-sale prices and then work out the problem assets and recoup their investment plus profits. This form of distressed investing was instrumental in lifting financial markets out of previous crises (e.g., the crisis during the summer of 1998 precipitated by the Russian default and the Long-Term Capital Management debacle).

This recovery process was halted by the unexpected events of the weekend of September 13-14, 2008 – dubbed by the Wall Street Journal as “the weekend that Wall Street died” – which culminated on September 15 in the bankruptcy of Lehman Brothers and the acquisition of Merrill Lynch by Bank of America. Large financial institutions were thought to be “Too Big to Fail” (TBTF) because of their importance to the operation of global financial markets. That is, it was widely thought that the government could not afford to let any of the largest banks fail because of the knock-on impact of losses that would ripple through the entire financial system. Lehman Brothers was widely believed to have a TBTF implicit guarantee, particularly after the government bail-out of Bear Stearns in March 2008. It came as an enormous shock to financial markets that US regulators did not offer a bail-out package to Lehman. The systemic ripple effects were massive, extending to all financial markets. Concerns about haphazard governmental interventions as evidenced by the apparently inconsistent application of TBTF principles contributed to the ensuing downturn that I refer to as the third phase of the crisis. During this phase, credit risk and liquidity risk were again exacerbated, so that the third phase of the crisis includes a repeat of both phases 1 and 2. That is, the deterioration in financial and economic conditions triggered a lock-down in financial markets (liquidity risk exposure) and increase in delinquencies (credit risk exposure).

On top of the governmental policy risk associated with haphazard and inconsistent application of intervention policies (e.g., the changing objectives of the Troubled Asset Relief Program, TARP, established on October 3, 2008), it became apparent that there was something fundamentally unsound in the way that underwriters had implemented the securitizations during the bubble years. It was becoming increasingly clear that vulture capitalists were finding it difficult to recoup their investments in the so-called toxic asset-backed securities because of the complexity and difficulty in valuing many of the distressed assets. Specifically, fundamental structural problems in the underwriting of MBSs and other toxic securities were becoming apparent. For example, when distressed asset investors attempted to foreclose on the underlying loan collateral, they often found that the underwriters, in their hurry to do the deal and securitize the loans during the boom period, failed to perfect the liens. They found that some securitizations did not have fundamental identification information about the underlying assets necessary to restructure the securitizations. They also found that in some deals the right to restructure the securities was limited by covenant. That is, in their rush to do the deals during the bubble period, underwriters failed to follow their own due diligence and operational procedures. As noted by Gretchen Morgenson of The New York Times (December 28, 2008):

“[L]awyers who represent candidates for modifications [of MBS] say the programs are hobbled by the complexity of securitization pools that hold the loans, as well as uncertainty about who actually owns the notes underlying the mortgages.

Problems often emerge because these notes – which are written promises to repay the full amount of a mortgage – weren’t recorded properly when they were bundled by Wall Street into pools or were subsequently transferred to other holders.

How can a loan be modified, these lawyers ask, if the lender cannot prove that it actually owns the note? More and more judges are asking the same thing about lenders trying to foreclose on borrowers.

And here is another hurdle: Most loan servicers – the folks responsible for handling all the paperwork surrounding monthly mortgage payments – aren’t set up to handle all of the details involved in a modification.”

The weekend of September 13-14, 2008 started the process of revelation of the fundamental underwriter risk and governmental policy risk hazards of the financial crisis (e.g., the changing objectives of TARP) thereby sending financial markets into steep declines that have continued to this day. Despite the stock market rally of this past week, global financial markets cannot find a floor since investors are leery about purchasing ABS even at fire-sale prices for fear that underwriting lapses will prevent them from restructuring the securities and earning a return on their investment. Thus, securities prices keep falling, as potential buyers sit on the sidelines.

If the diagnosis is the inability to allocate legal property rights to the toxic assets because of failures in due diligence and legal claims during the underwriting stage, then bank capital infusions are the wrong remedy. It is long past time that these toxic assets were quarantined in a government Resolution Trust RTC-style entity that would use subpoena power to work through the legal tangle of ownership claims. This would remove the uncertainty about the toxic assets’ valuations from bank balance sheets. Once that happens, private capital markets should reopen to recapitalize the banks and other entities. The government should not be quasi-nationalizing the banking system. This has become apparent as companies (even GM) refuse government bail-out money that comes with more and more onerous strings attached.

So, should the government sit back and not respond to this economic crisis? No. It should be the government that controls the restructuring of the toxic assets placed in the RTC “bad bank.” This is not a job for the private sector, because it will take time and may entail abrogation of some poorly identified contractual specifications (for example, limitations on the number of loans in the mortgage pool that can be restructured). The government should take on this responsibility and reap whatever reward can be obtained from the resolution. During the thrift crisis in the 1980s, the RTC returned more than $300 billion to US taxpayers from its disposition of the assets of failed thrifts. In President Obama’s “public/private partnership,” the US taxpayer takes the risk and the private investor reaps the reward. That’s not a partnership – it’s exploitation. Haven’t we had enough of that?