Primary Market – Loan Originations
Fannie Mae and Freddie Mac do not originate mortgages. More than 80% of subprime loans still outstanding were originated in 2004 through 2007. The top ten subprime loan originators in 2006 were: HSBC Finance, New Century Financial, Countrywide Financial, Citimortgage, WMC Mortgage, Fremont Investment and Loan, Ameriquest, Option One, Wells Fargo Home Mortgage and First Franklin Financial. Seven of the ten (the nonbank lenders, who were not regulated by the Community Reinvestment Act) no longer exist, or were merged into banks. The lists for 2005 and 2004 were similar, but also included Washington Mutual. The top ten lenders accounted for about 60% of ALL subprime loans in 2006.
Secondary Market – Wholesale Loan Buyers
In 2004, 2005 and 2006, securitized mortgages were 73%, 79% and 81% of all subprime mortgages. So for practical purposes the wholesale market was the securitization market. For the same three years, the total volume of subprime loans securitized was $521 billion, $797 billion and $814 billion respectively.
Almost none of those securities were issued by Fannie and Freddie. They were not in the business of purchasing and securitizing subprime mortgages, although they purchased some subprime mortgages to hold in portfolio, and issued about $6 billion in subprime securities in 2004 to 2006 (one-third of one percent of the market.) The top fifteen issuers of subprime mortgage-backed securities, accounting for about 75% of the market, in 2006 were: Countrywide, New Century, Option One, Fremont, Washington Mutual, First Franklin, Residential Funding (GMAC affiliate), Lehman Brothers, WMC, Ameriquest, Morgan Stanley, Bear Sterns, Wells Fargo Securities, Credit Suisse and Goldman Sachs.
Investors in Subprime Mortgage-Backed Securities
After the securities were issued, investors were needed to buy the securities, and thus to fund the mortgages. At this third stage, Fannie and Freddie did play a role, albeit a minor one. As of 12/31/07, Freddie held $234 billion and Fannie held $112 billion in subprime securities, out of a total market of $2,116 billion (i.e. $2.1 trillion). Most of these purchases took place in 2005 and 2006. A significant chunk to be sure (about 15%) but if you took out the GSE purchases, there would still have been a huge subprime market, and there is no way to know whether other buyers might have purchased those same securities if Fannie and Freddie had not (i.e. their presence was probably not vital to the growth of subprime lending and securitization.) Other purchasers of subprime securities included banks and thrifts, foreign investors including sovereign wealth funds, mutual funds, hedge funds, insurance companies, state and local governments, private pension funds, and wealthy institutions and individuals. It is also worth noting that Fannie and Freddie started buying subprime securities late in the game, years after the subprime mortgage market had been launched and its dangerous products deployed.
At the time that Fannie and Freddie were making the investments in subprime mortgages, those mortgages made up about 20% of all mortgage originations, and Alt-A made up another 12% of the market. So, even to the extent that Fannie and Freddie did invest in subprime mortgages, their exposure was smaller than the subprime share of the market as a whole. In other words, Fannie and Freddie had conservative mortgage investments compared to the market as a whole.
When Did Market Failure Start?
The government did not intervene significiantly, and appropriately so, in the market's virtually complete abolition of the subprime market going forward, and with it, most of the major private sector players in that market. While the market reaction is probably an over reaction, and I think it is safe to say that there is room in the economy for smaller scale and more cautious subprime lending at some future date, the market's knee jerk reaction has stopped the bleeding and preventing hundreds of billions of dollars of economically unwise new deals from going forward.
Of course, at this stage, the financial crisis has ventured far beyond the subprime lending industry. Credit enhancement guarantees (a form of derivative known as credit default swaps) gone bad on mortgage backed securities have thrown major insurer AIG into financial distress leading to a bailout of the insurer. Every major independent investment bank has gone down, as defaults in mortgage backed securities have upset their fragile, highly leveraged balance sheets. A money market fund then broke the buck because their lending to one of these investment banks went bad, causing a crisis of confidence in the money market industry. Commercial banks have grown unwilling to lend to each other for fear of a major bank collapse, in the wake of the collapses of Washington Mutual and Wachovia. The stock market has tanked across the board in the face of widespread credit market uncertainty. All of these eventualities combined are contributing to a looming recession.
Securities Regulation Gaps
So, what went wrong?
A good portion of the spread of the subprime mortgage problem can be traced to poor disclosure, something that is regulated by the securities laws.
Insufficient Segement And Line of Business Detail
The risks associated with mortgage backed securities weren't adequately understood, and the portfolios are still hard to evaluate even in hindsight with publicly available information. Securities laws, investors and bond rating companies did not demand sufficiently detailed information to properly evaluate the risks involved in these investments, and did not cause the right kind of analysis of the risks to take place. This problem is not limited to mortgage backed securities. Disclosures by publicly held companies are universal, but too shallow to adequately evaluate the data in a quantitative way.
Too Many Key Players Are Exempt
The risks associated with the derivatives market are also poorly understood, mostly because it is hard to know what derivatives are outstanding, and because it is hard to evaluate the ability of privately held parties to credit default swaps to sustain losses without going bankrupt. This is a situation where the scope of public financial disclosure matters as much as the level of detail in the disclosure made by publicly held entities that have to engage in disclosures.
The securities laws (or the SEC regulations that implement them) need to be amended to require disclosure from any entity whose ability to make good on its obligations to a publicly held company can materially impact the financial health of the public company. If financial distress at a private equity fund or hedge fund can bring down a publicly held company, it needs to be making the same kinds of public disclosures as publicly held companies, at least in any respect that is potentially material to a publicly held company.
It Isn't Just Greed
Also, while it has become popular on the Street to blame greed, we can't have financial markets without it. The problem is not greed, but financial and regulatory structures that don't properly channel greed. Full disclosure can scare greedy, ammoral investors enough to prevent bubbles from getting out of control. But, the non-disclosures identified above that were important factors causing the crisis weren't required by federal securities laws as customarily implemented.
The problem was not so much major financial institutions lying in their disclosures. They simply did what comes instinctively to business people and their lawyers, which is to disclose only what they were required to disclose. Indeed, there was almost certainly boilerplate vague language specifically pointing out the risks that actually went bad in their prospectuses. The problem was that period disclosures don't require the level of detail necessary to see the risks. Financial statements give a false sense of security, because they are ill suited to evaluating contingent liabilities, and rarely flag problems in particular divisions or market segments of a company that can take down the whole company. The market has responded by disfavoring conglomerates in the stock market, but the market's interet in transparency in segement disclosure always has to be balanced by the economies of scale that can flow from having multiple related lines of business.
Similarly, one can hardly blame private equity firms and hedge funds for not disclosing information to the SEC and the public that they are clearly exempt from providing under existing law. The costs associated with providing regular, audited, public disclosures is one of the reasons that private equity funds and hedge funds don't go public.
But, interia and division (some fostered intentionally by Congress and the Executive Branch and industry lobbyists) on the part of regulatory agencies like the CFTC and the SEC, compounded by timidity on the part of credit rating agencies and sophisticated investors that led them not to demand private information necessary to gauge the real risks that they were taking, created systemic risks in the economy and produced legions of poor investment decisions.
In the case of mortgage backed securities, investors frequently abdicated their own due diligence to bond rating agencies, and bond rating agencies have lacked the means or incentives to do a careful enough job. Too little time was spent in evaluating each mortgaged backed security issurance, and equally important, too little time was spent by the mortgage security specialists within those institutions looking at the forest rather than the trees and evaluating systemic risk. If they had paused to evaluate systemic risk for the industry as a whole to a greater extent, they might have started asking more of the right questions and downrated many of these bonds upon issuance or, at least, much earlier.
Bad disclosure isn't the only problem. Excessive leverage in key financial institutions, and by individuals are two other problems. Poor incentives for senior executives of publicly held companies that encourage excessive risk taking in exchange for short term gains is another. But, those problems are beyond the scope of this post.
Oligopoly and Group Think
Another key observation in the quoted material is how much the subprime and mortgage backed securities markets were dominated by a small number of players, even though neither Fannie Mae nor Freddie Mac were among those important players except at the very tail end of the process.
Eleven loan originating institutions and six investment banks (seven if you count Wells Fargo Home Mortgage separately from Wells Fargo Securities), dominated the origination and securitization of subprime loans.
It would be interesting to see how many overlapping appointments to corporate boards of directors linked those firms. In all likelihood, the number of human beings at the helm of this organizations collectively numbered in the high dozens. I suspect that within that group, everyone knew each other. Mostly, they also came from very homogeneous backgrounds. The senior ranks of big business America are far less diverse in background and outlook than say, the politicians in Congress, and this is even more true when one confines oneself to a particular industry like mortgage lending.
The good news is that all of the non-bank lenders are gone or have merged into better run companies now, as are most of the investment banks involved. Most of the lower profile second tier subprime mortgage originators and securitizers are gone too. This suggests that there is light at the end of the tunnel. To the extent that our current financial crisis was driven by the subprime mortgage industry's sudden collapse, there may not be many more shoes left to drop out there.
The cautionary news, however, is that government and the markets cannot trust big, industry dominant players to remain above the group think that leads to systemic risk. Markets are an implicit endorsement of the idea of the "wisdom of crowds." But, the virtues of this kind of collective decision making fall apart when a small number of oligopolistic decision makers dominant an industry (which appears to be almost inevitable in most cases), and those decision makers give in to group think (which is not inevitable).
The Case Of The Automobile Industry
We see the same thing in the U.S. automobile industry. Faced with the same market, all three of the Big Three U.S. auto makers bet big on light trucks and sport utility vehicles while slighting fuel efficiency. When that collective decision turned out to be a poor one, all three companies have wound up in trouble. The only reason that the entire worldwide automobile industry hasn't collapsed is that foreign automakers, that have management teams that are culturally removed from the Detroit automobile industry, didn't fall prey to this group think. Toyota and Honda zigged where Ford, General Motors and Chrysler zagged.