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Role of Fannie Mae, Freddie Mac, Lehman Brothers and AIG Insurance in the melt downDate:October 6, 2008
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The subprime industry created a profitable eco system for Wall Street of unscrupulous mortgage originators, a gullible public that bought the houses which the bulk of its members could not afford (mostly with teaser introductory rates which would go up after a few months), rating agencies that used sophisticated models to justify high rating for these securities and investment banks who were packaging and selling the securities to investors the world over. Fannie and Freddie had a congressionally mandated role to guarantee mortgages that were mostly "prime" and those mortgages are still doing reasonably well. However, since the two are structured as private corporations, management and leadership had every incentive and were under constant pressure to increase the "earnings." This coupled to their compensation structure drove the firms to take on ever greater risk by investing outside their core mandate into these subprime securities and derivatives linked to the value of subprime securities. The goal was to increase their quarterly earnings, which in turn boosted the compensation of the top management; and given their clout in Washington, there was no oversight on this blatant deviation from their original mission. Since Fannie Mae and Freddie Mac always had the implicit guarantee of the U.S. Treasury they could raise enormous sums of debt at very low rates (almost at treasury rates) and then deploy the funds in subprime mortgages to earn a better spread, thereby boosting their quarterly earnings and compensation of the management whose earnings were tied to the firms’ short-term earnings. Lehman was a key player in the mortgage securities business and made its own investments in subprime mortgage securities to boost the return. By borrowing heavily short-term funds at rock-bottom rates (given that Fed had kept rates low for a long time) and then investing them in subprime mortgages, they were also able to boost their quarterly profits. All this was driven by the need to pump up earnings to earn their management’s compensation payout, even as the firm was taking on enormous debt and having to leverage close to 40 times its capital. AIG was a profitable well-run insurance company which found the "easy money" in mortgage business and decided to be the insurer by offering a product called "credit default swap," basically an insurance to the buyers of mortgage security that if they don’t get their money back for some reason AIG will pay the holder of security. Basically AIG was insuring all the subprime mortgages and earning a premium for doing so. Fannie, Freddie, Lehman, AIG and pretty much most of the Wall Street was betting that U.S. housing prices will continue to rise "forever". So when the US housing prices crashed the subprime mortgage business collapsed as the home owners defaulted massively on their mortgages which created a ripple effect in making these mortgage securities worthless. A subprime homeowner had no incentive to pay off a mortgage, which was worth more than the house and decided to walk away as they had taken a "zero down" mortgage and no equity in the house. The worth of these securities was resting on the assumption that home prices will not lose value. However, when they did, the entire subprime market unravelled. Firms like Lehman, Fannie and Freddie, who had enormous investments in subprime securities relative to their capital base, had to book losses and there was no one ready to buy these securities. Given the precarious state of U.S. housing market, the entire mortgage securities market seized, which spilled over to the broader credit market since no one knows who has how much exposure and what is the true value of these securities. So when one firm starts selling these securities at distress prices it triggers a wave of writedowns in other firms as the value of these securities has to be adjusted to reflect market value "using the mark-to-market rule." This created further selling pressure and soon there was no buyer for these securities. Truly, the chickens had come home to roost. Overnight, firms like Lehman, Fannie and Freddie essentially had no capital left and no way to raise capital as they had lost the confidence of the markets and had to either declare bankruptcy or be taken over by the U.S. Government. Fannie and Freddie being the guarantor of 50% of U.S. mortgages (mostly prime) with investors around the world holding their securities, the U.S. Government had to bail them out by taking over. Also, if they were not bailed, the mortgage interest rates in U.S. would have skyrocketed. Lehman had no such luck and had to declare bankruptcy. AIG, which had effectively insured the holders of these securities, had to come up with funds to pay the mortgage security holders as they lost their value and they obviously did not have the capital to pay up. It is worth noting that that AIG had over a trillion dollars in assets and if AIG were to collapse all the financial institutions that had securities insured by AIG through Credit default swaps would take a hit, creating a global meltdown. Any wonder then that the U.S. Government intervened to keep AIG alive by offering an emergency line of credit? Vishy Karamadam is a Director in Ubika Research, an independent research firm based in Toronto. He can be reached at vishy@ubikacorp.com |
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