America’s ‘Bad Bank’
Posted on: February 3, 2009 - Email Article - Printable Version
The origins of our altered financial landscape can be traced back to 2003, following the tech crash of the years prior. Alan Greenspan cut the federal funds rate to 1%, holding them steady for an extended period. The purpose of the rate cuts, similar to today, was to stimulate economic growth (via liquidity). Unique to the policy in 2003, however, was an increased focus on cheaper access to credit for those borrowers traditionally unable to obtain financing for housing. Fannie Mae’s affordable housing and home improvement lending programs created a new market of Alt-A and subprime mortgages.
Securitization is a structured finance process, where the cash flows from a pooled group of assets are broken into tranches and distributed according to varying investor risk tolerances. The idea is safety through diversification of risk. While one of the mortgages within a securitization pool may default, based on historical data, the likeliness of a significant portion of the pool going bust was improbable to say the least according to the quantitative models. With this huge influx of subprime mortgages, the investment banks were forced to package them and break them up into varying risk levels. This lead to securitized pools composed completely of subprime mortgages that could assign certain tranches a AAA credit rating. This was achieved by positioning the payout structure of the securitized mortgage pool such that the default rate of these lower grade mortgages would have to be much greater to affect the AAA tranche than that of a traditional pool of mortgages.
In late 2007 the housing market stopped appreciating and a number of these adjustable-rate subprime mortgages
reset. When the second largest market in the world, the $13 trillion mortgage market, starts to stumble, the spillover will be felt throughout the economy. Please note, nothing I have said is in opposition of securitization. I think it is one of the most brilliant creations in finance. I simply contend it was a contributor to the current economic state of affairs.
T.A.R.P. and America’s ‘Bad Bank’
The authorization of the $700 billion T.A.R.P. program began with the intent of buying up troubled assets from banks’ balance sheets. As you most likely know, even the banks that were thought to have been the strongest have shown signs of significant weakness in regards to these troubled assets on their balances sheets. Difficultly in valuing these securities, however, forced the Federal Reserve to resort to much needed capital injections. As Obama recently authorized the second half of this $700 billion, the outcome of such Federal Reserve maneuvers will be unclear for some time.
Interestingly, the market rallied this past Wednesday as plans for the possible creation of a national ‘bad bank’ structure were announced. Similar to the original intention of the T.A.R.P. program, this vehicle would buy up the toxic assets held on the banks’ balance sheets, allowing them to dispose of a large portion of uncertainty held on their books. The implication of such a structure, specifically how much ownership/control this would give the government in these companies’ future operations, is still unclear.
Multi-Billion Dollar Decisions
One of my biggest concerns is that several of the politicians responsible for making many of these multi-billion dollar bailout/resource allocation decisions are making them outside of their area of expertise. As an example, Barney Frank, the chairman of the House Financial Services Committee, has no educational background in finance and a rather poor track record. In 2003, Frank opposed Bush administration proposals to transfer oversight of Fannie Mae [FNM: 1.07, +0.06 (+5.94%)] and Freddie Mac [FRE: 1.28, +0.09 (+7.56%)] by creating an independent agency to supervise. Frank stated that the bill 
would potentially weaken “the bargaining power of poorer families and their ability to get affordable housing.” Indeed, Frank has been criticized for the size of campaign contributions he has received from Fannie and Freddie over the course of the past decade.
However, this is not a criticism of Barney Frank specifically. I have no doubt that this Harvard graduate is a brilliant mind. With a background in LGBT, online gambling and free speech advocacy, however, I am weary of someone like Frank having control over such crucial decisions. In one of my favorite quotes, Winston Churchill states, “Democracy is the worst form of government except all those others that have been tried.” While democracy is beautiful for what it is, reelection from your constituents is a powerful motivator no matter how altruistic one is at the onset. I hope future decisions regarding our economy are left to those most educated in the field.
-Adam Brown
Disclosure: None
The Following Stocks Were Mentioned In This Article: FNM, FRE
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