How Driftwood Will Turn $2 Billion into $100 Billion With Two Permits and Bechtel. What Happens When Political Delusions Run Headlong into Economic Realities.  

Sunday, September 7th, 2008 was a bad day for Hank Paulson.

The U.S. Treasury Secretary (and former CEO of Goldman Sachs) was dealing with a financial Armageddon – one he’d lied about.

In 2005 and 2006 Wall Street’s leading investment banks (notably Merrill Lynch, Lehman Bros, Bear Stearns, and Goldman Sachs) made fortunes by packaging thousands of individual mortgages into securities they could trade. The fees for creating these “collateralized debt obligations,” or CDO’s, were typically around 2% of the total issuance. In 2005 Wall Street firms packaged $178 billion worth of mortgages into CDO’s.

The banks were making so much money from mortgages – billions – they began buying entire mortgage underwriting firms to gain more control over the supply of mortgages. But even that couldn’t satisfy the market’s demand for CDO’s.

In 2006, total Wall Street mortgage-related CDO issuance was a staggering $316 billion!

Innovations and “big ideas” in the financial markets tend to follow an arc, that repeats, time and time again. At first the new innovation provides clear benefits for both customers and bankers. That leads to widespread acceptance and growth in the new financial product or strategy.

That’s what happened with mortgage securities too. Thirty years ago, when Salomon Brothers began packaging prime mortgages into securities to sell to local banks across the country, it was a good way for local banks to diversify their portfolios and make their assets safer.

The growth of the new “thing” leads competitors to “pile on.” Every bank on Wall Street eventually creates copycat products that lead to more and more bankers chasing the same customers and more and more customers chasing the same kinds of investments. Sooner or later whatever advantages the early investors earned disappear as prices and fees keep increasing because of growth in demand.

That’s when what was at first a good idea becomes a farce. In mortgage securities, the farce began in 2005 when Merrill Lynch stormed into the business. Merrill, whose core business was retail brokerage, was hardly an investment bank. It had zero expertise in mortgages or in creating derivatives. But a complete lack of experience didn’t stop them: In a span of 24 months, they made 12 major acquisitions related to the mortgage industry, including the $1.6 billion acquisition of First Franklin, a major subprime mortgage lender.

And that’s when things really got weird.

The banks soon discovered it was cheaper and faster (and far more profitable) not to bother with underwriting or purchasing mortgages at all. Demand for CDOs was so strong that investors were willing to invest in insuring existing CDOs – securities Wall Street had already packaged. Investors were willing to make these very risky bets because, for more than 50 years, real estate values had only gone up. Thus, in the eyes of many investors, mortgage securities were a de-facto risk-free asset. Investors were seeking more risk in housing – not less.

Wall Street obliged by creating “synthetic” CDOs. These were insurance contracts (credit default swaps, in the language of Wall Street) that guaranteed the performance of the underlying mortgages in CDOs. These securities allowed investors to invest in specific levels, or tranches in the parlance, of mortgage risk. They allowed Wall Street to sell investors the same piece of mortgage paper, multiple times, which seemed like nirvana to the bankers. And, in the very short-term it did create a lot of profits and bonuses. But it also magnified and concentrated the financial risks of the mortgage security business enormously.

Finally, in the final phase of this classic Wall Street drama, when everything starts to fall apart, what was only a farce becomes a fraud, as everyone tries to avoid holding the bag.

In the background of the mortgage/real estate mania, the Federal Reserve had been gradually raising interest rates since 2004. By 2007 interest rates were 5.25%. That’s when the music stopped.

Mortgage default rates began moving higher, faster than anyone had ever seen before. And the value of Wall Street’s CDOs collapsed in turn, starting with the riskiest tranches. In the summer of 2007, the entire subprime mortgage industry imploded. And Wall Street’s losses mounted. Quarter after quarter, the mark-downs and the write-offs grew and grew. Soon the losses were in the billions.

Bear Stearns was the first to collapse, in the spring of 2008.

The big problem on Wall Street wasn’t really the CDOs they had already packaged. The big problem was, given the collapse in the value of existing CDOs, there wasn’t any practical way for the major investment banks to sell the billions in subprime mortgages they owned in their “warehouses” – mortgages they were in the process of packaging in securities. Nobody would buy CDOs anymore. Making matters worse, the banks also retained billions worth of the “super senior” tranches of the synthetic CDOs they built. (Notably these were also the securities that doomed AIG.) These were securities that were backed by the underlying value of millions of prime mortgages and were AAA-rated. The rating implied that there was virtually zero risk of default, which meant regulators didn’t require much underlying collateral against these assets. And that meant the banks (and AIG) could hold virtually unlimited quantities of them, without any underlying collateral.

But, as the prices for CDOs were getting worse each week, and as mortgage default rates continued to increase, many of the “super senior” securities suffered ratings downgrades, which meant banks had to post collateral. And, as the banks were highly leveraged (in some cases 50-to-1) the amount of collateral required was gigantic. By July of 2008, Merrill had written off an incredible $46 billion in mortgages and was trying to raise $8.5 billion in new stock to post as collateral.

But Treasury Secretary Paulson’s real problem was Fannie Mae and Freddie Mac.

These were the two enormous government-sponsored enterprises (GSEs) that sat at the very center of the mortgage industry. On a combined basis, these two firms provided more liquidity to the U.S. mortgage market than any other firms, by a wide margin. They owned or guaranteed almost $5 trillion worth of mortgages (roughly half of every mortgage in the country) – and were leveraged 68-to-1.

In May of 2008, a well-known (loud, throat-clearing sound here) financial writer from Baltimore told people the truth about the unfolding debacle at the GSEs.

“Freddie and Fannie own or guarantee 45% of all of the mortgages in the United States – $4.8 trillion worth of mortgages. But looking only at the mortgages they actually own and hold on their balance sheets, you find mortgages with a face value of $1.7 trillion. They hold these assets with only a sliver of equity, about $70 billion in “core” capital. On a combined basis, they’re leveraged by a little more than 24-to-1. Thus, a 5% loss in the value of their mortgages would wipe out 100% of the equity in each firm. Looking beyond their balance sheets to their off-balance-sheet guarantees, you see that they’re actually leveraged 68-to-1, meaning a 1.4% decline in the value of their total on- and off-balance-sheet would wipe out shareholders.”

“Nationally, the average price of a home has now fallen by more than 15%. The delinquency rate for all residential mortgages at the end of the first quarter of 2008 was 6.35% – a record high. In addition, the percentage of mortgages in foreclosure is now 2.47%, up almost 100% from last year. Adding the two numbers together, you see that nearly 9% of all of the mortgages in the United States are either in default or in foreclosure. The Census Bureau reports that about 10% of houses built after 2000 stand vacant. This is unprecedented.”

“Fannie Mae and Freddie Mac, the two largest and most leveraged owners of U.S. mortgages are sure to go bankrupt in the next 12 months. Congress may decide to assume their liabilities, to prevent an unprecedented global financial calamity, but Congress won’t bail out the firms’ shareholders. Fannie Mae and Freddie Mac are going to zero.”

“Freddie Mac and Fannie Mae Are Going to Zero,”

-Porter Stansberry’s Investment Advisory, May 2008

Government officials were not nearly as forthcoming.

On July 15th, 2008, Hank Paulson publicly brushed aside the notion that the giant GSEs at the center of America’s banking system were in trouble. Fannie and Freddie are “well-capitalized,” he told the Senate Banking Committee. It was a bold lie. Six days later, while meeting with a dozen large hedge fund managers (most of whom were ex-Goldman executives) at the offices of Eton Park Capital in New York, Paulson told a different story. The Treasury planned to seize the businesses, which would wipe out the shareholders.

The financial losses suffered by Fannie and Freddie totaled an incredible $265 billion. The political delusion that every American could afford a home met the cold, hard reality that surprisingly few Americans are credit worthy enough to borrow large sums of money against fixed assets. Home ownership for millions was just a financial illusion: they were living in a credit bubble, not a house. Fannie and Freddie created the bubble. Now they were bankrupt almost 4-times over. Paulson knew millions of people were about to lose their homes. And on Sunday, September 7th, Hank Paulson announced that both Fannie and Freddie were insolvent and would become wards of the Treasury – a “conservatorship.”

Without Fannie and Freddie, there was no functional market for mortgages. A week later, on Monday, September 15th, Lehman Brothers failed and declared a $600 billion bankruptcy. Lehman’s bankruptcy was an order of magnitude (10x) larger than the previous biggest bankruptcy in U.S. history: Enron’s collapse in 2001. Lehman’s losses were staggering. In the first two days of Lehman’s bankruptcy, JP Morgan, backed with guarantees against losses by the Federal Reserve, had to provide Lehman with $138 billion in funding.

The next week, Merrill Lynch failed – but technically avoided bankruptcy by way of a Federal Reserve arranged sale to Bank of America. Again, the losses were hard to comprehend. The portion of Merrill’s $260 billion (!) CDO inventory that could be sold, went for only $0.22 on the dollar. Shareholders at Bank of America only approved the merger because Merrill’s losses were fraudulently withheld from the public. When the true extent of the losses was revealed, Bank of America’s stock lost half its value — $50 billion – in just four trading days.

Following Lehman’s collapse, the Federal Reserve would go on to offer $7.7 trillion worth of loan guarantees and swaps with financial institutions around the world. Without trillions in government financial guarantees to stem the panic and cover the losses, most of the world’s major investment banks would’ve failed. The resulting cascade of losses would’ve immediately destroyed major U.S. companies, like General Electric, which was completely reliant on Wall Street’s short-term money market.

So… where did all the money come from…? The Federal Reserve printed it, of course.

The Federal Reserve’s balance sheet immediately doubled, from under $1 trillion to over $2 trillion. An entire smorgasbord of new financial programs, with ridiculous names and acronyms, like TARP, sprang to life. The Fed bought billions of mortgages to bail out the banks and later, as the government ran massive deficits to spare the economy a cleansing recession, it bought trillions in Federal debt.

By the end of 2013, the Federal Reserve balance sheet rested at $4 trillion – a four-fold increase to our monetary base from pre-crisis levels.

SNOWFLAKE ECONOMICS

This week’s letter, believe it or not, isn’t about mortgages or investment banking… or even specifically about corrupt government officials. This week’s letter is about what happens when politics collide with hard economic realities.

The mortgage debacle is a perfect case study.

So, who is responsible for the mortgage crisis and the trillions of losses investors suffered because of widespread mortgage fraud?

Fannie Mae and Freddie Mac were, by far, the largest providers of capital to the mortgage market. Their guarantees created the market. In fact, without the financing they provided to the system, the 30-year, fixed rate mortgage wouldn’t exist. Why not? Because it’s far too risky to offer such long-term financing at fixed rates in a government controlled, fiat currency.

Their dominance in providing capital meant their underwriting standards were the industry’s standards. Fannie Mae and Freddie Mac dictated who could get a mortgage in the U.S. and under what terms. While this power wasn’t explicitly granted to them, if your mortgage didn’t conform to their standards, it couldn’t be packaged and sold to them, which meant, it wouldn’t be underwritten by most mortgage banks.

The problem was, Fannie Mae and Freddie Mac were not rational economic actors. Even though they had shareholders, they were primarily instruments of government policy. Fannie and Freddie, much like Medicare and Social Security, offer the public the promise of enormous economic benefits, without any apparent costs. They are, if you will, a central feature of our country’s “snowflake” economic system. They offer consumers what they believe they’re entitled to have – regardless of the underlying economic reality.

In the imaginary world of snowflake economics, Social Security isn’t a tax or a liability of the federal government. It’s “insurance.” But, what about the trillions in unfunded liabilities of the program? They are not anywhere to be found on the government’s balance sheet. They don’t exist in snowflake economics. But they certainly exist in real life.

Likewise, the financial risks that Fannie and Freddie assumed on behalf of the U.S. financial system were never on the government’s books. But where did the $265 billion bailout come from?

And here’s what most people don’t know and will never be told. The GSEs were bound to fail. They were designed to fail. There is no way they could’ve not failed – at least not after 1992.

In that year, Barney Frank, the liberal Congressman from Massachusetts (and the first openly gay member of Congress), decided that the government should help more Americans buy a home – even if they couldn’t afford one. Frank led efforts to force Fannie Mae and Freddie Mac to buy mortgages held by poor people. The Housing and Community Development Act of 1992 required the GSEs to show that 30% of the home mortgages they bought were made to people with incomes at or below the median income in their communities.

More importantly, the Department of Housing and Urban Development was granted the authority to adjust this regulation. Frank was determined to give mortgages to poor people and for that power to be a major part of the Democratic Party’s economic agenda.

He didn’t waste much time. In 1996, with a Democrat (Bill Clinton) in the White House running for re-election, the GSEs median income quota was raised by 50%. Half of Fannie and Freddie’s mortgage buying would be reserved to help poor people have access to mortgage credit. Then, under the GW Bush’s Administration, Barney Frank was able to push it all the way to 55%.

How could any leveraged financial institution survive an underwriting policy that specifically required it to buy mortgages from mostly poor people, who inevitably had weaker credit? Maybe through massive scale? No way.

By 2002, Fannie and Freddie owned well over $1 trillion of subprime and other low-quality mortgages. The other Federal lending agencies joined the fun too – the FHA, Federal Home Loan Banks, Veterans Administration, etc. all provided virtually unlimited mortgage financing to poor people with bad credit. As a result, by 2008 there were 27 million subprime and other low-quality mortgages. That was half of the mortgages in the U.S.

And of these low-quality mortgages, 70% were on the books of either a GSE or another government agency.

In 2003, when the bubble in mortgage finance was becoming obvious and as home prices soared, Barney Frank was asked about the inevitable consequences of giving people mortgages they couldn’t really afford. Sooner or later, there was going to be a reckoning. Frank explained, “I want to roll the dice a little more in this situation toward subsidized housing.”

And maybe there were other considerations too. Fannie and Freddie weren’t merely providing benefits for poor homeowners.

The growth of their portfolios made them the biggest economic engines of the D.C. swamp. They became a legal means for powerful Congressmen to enrich themselves and assure their own re-elections. In the ten years leading up to the 2008 crisis, Fannie and Freddie spent a combined $170 million on direct lobbying – the biggest lobbying budget in the country. Their executives gave another $16 million in direct political donations. They have also hired many former members of Congress and powerful Congressional staffers – Democrats, of course — giving them plush jobs with no real responsibilities. The GSEs even went so far as to open “outreach” offices in powerful Congressional districts where they served as a constant reminder to voters that it was the Democrats who got them their mortgages.

Incredibly, even after the damage caused by GSEs in the mortgage crisis, they still exist!

Of course, their liabilities are nowhere to be found in the Federal budget – it’s snowflake economics. Legally they still exist as private enterprises. But the Supreme Court ruled in the case of Collins v. Yellen in 2021 that it was perfectly legal for Congress to seize all their profits, year after year, even long after the GSEs had repaid the government for their bailout. In other words, the standing of these companies as separate from the government is entirely a legal fiction.

And what is the Biden Administration doing with their mortgage banks? Last September, the Biden Administration doubled the size of mortgages Fannie and Freddie can purchase and ordered the GSEs to implement “Equitable Housing Finance Plans.”

Those plans became public last week. Fannie’s plan includes efforts to encourage “sustainable homeownership for Black consumers,” by giving Black borrowers down payments. It would also provide “loan level price adjustments,” for Black home buyers. Lenders normally require higher interest rates for borrowers with lower credit scores. Fannie plans to offset those rates to “reduce obstacles for prospective Black homeowners.” Its policies are specifically targeted towards Black homeowners, not other minorities, or low-income white borrowers.

The Constitution clearly prohibits race-based preferences in government policy… but Fannie and Freddie aren’t government agencies. It’s perfect snowflake economics. Biden’s administration gets to spend billions on a targeted (and heavily Democratic) special interest group, without having to go through Congress.

There’s no downside – after all, these are merely loans.

The worst aspect of these policies is: the people they will hurt the most are the people the politicians claim to help. Helping someone buy a home they can’t afford is an enormous mistake – even if they didn’t make a down-payment. Radically increasing mortgage credit will cause a big, but temporary, increase in demand for housing. But it isn’t sustainable if the homes are actually affordable. Eventually the borrowers will default. And that will set off a cascade of failed communities and lower housing prices. A lot of borrowers will get hurt.

There’s no free lunch, snowflakes.