This country is undergoing an unprecedented mortgage crisis. I can't go into all the details right now (buy my book after it's finished!). It is estimated that 2.5 million people will end up in foreclosure by the end of 2008. Many of them were truly suckered into obtaining terrible mortgages by lenders who stood to make huge fees from selling risky mortgages. The lenders would offer the mortgages, then turn around and sell them to Wall Street firms who would "securitize" the loans; in other words, Wall Street would package the loans into mortgage-backed securities so they could be traded. Wall Street is all about buying and selling and perceived value. The Street especially liked "subprime" mortgages, mortgages offered to people without consideration of their ability to repay, because investors begged to buy them because of their high yields. But a house is not a commodity or a stock, it's also a place to live, shelter, sanctuary. It has value beyond the financial.
The mortgage lender (such as Countrywide Financial Corp., the nation's largest lender of mortgages) gets the highest pay for the riskiest mortgages, so naturally those mortgages were emphasized by their brokers. These were baffling, complicated mortgages. Countrywide specialized in "pay option adjustable rate mortgages", where the borrower had the option to pay as little of the interest or the principal as desired, deciding on a month-by-month basis. Whatever the borrower didn't pay was added to the principal on the loan. The broker would coo in honeyed tones, "Don't worry, we'll help you refinance before your adjustable interest rate resets."
After the 2-3 year low "teaser" interest rate expired, the rate would reset, often to twice as high as before. Monthly mortgage payments on ever-increasing principal skyrocketed. When housing values started plummeting and people wanted to refinance their mortgages as promised, Countrywide was nowhere to be found.
Now that many homeowners are facing the grave loss of their homes, government, including Congress, are balking at helping these homeowners. They don't want to "bail out" people from the consequences of their risky decisions.
The government has no such qualms when it comes to the insane decisions made by financial institutions.
According to two recent (10/13 & 10/15) Wall Street Journal articles, the Treasury Department and Big Banks have been meeting for the last few weeks at the behest of Treasury's undersecretary for domestic finance, Robert Steel, a former Goldman Sachs Group Inc. official and the top domestic finance adviser to Treasury Secretary Henry Paulson. The parties involved are devising a way to bail out the banking industry on its bad bets on mortgage-backed securities and other exotic financial vehicles like collateralized debt obligations (CDOs). These bets were very bad, and a child could have predicted that. For one thing, they were predicated on the idea that housing prices would go up up up 20% annually forever.
The Treasury and the banks are creating a Superfund called M-LEC (Master-Liquidity Enhancement Conduit). [I've noticed the obscuring jargon of Wall Street has a lot to do with master-slave relations.) Citigroup, J.P. Morgan Chase & Co. and Bank of America will set up M-LEC to act as a buyer of last resort. It will buy the assets of what are known as SIVs at market price to prevent fire-sale dumping mainly because no one else wants to buy these assets anymore because for all anyone knows they may be worthless.
SIVs, or structure investment vehicles, are bank-affiliated funds legally independent of the banks that created them. They issue their own short-term debt, usually at low interest rates reflecting their high credit rating. SIVs use the money they get from selling their debt to buy higher-yielding longer-term assets such as mortgage-backed securities.
Many SIVs couldn't sell their short-term debt in August because investors didn't want to pay for something they thought could be worthless.
Some criticize the Treasury's role in seeking to help banks avoid a big financial hit for making bets that didn't pan out.
"I have never seen Treasury play this kind of role," said John Makin, a visiting scholar with the [conservative] American Enterprise Institute and a principal with hedge fund Caxton Associates LLC. The banks made "riskier investments that didn't work out. They should now put it back on their balance sheet."
There's a financial term for this: Moral hazard. A moral hazard arises if lending institutions believe that they can make risky loans that will pay off hugely if the investment turns out well but they won't have to pay if the investment turns out badly. They get all the gains on the upside and don't have to bear the consequences on the downside. In other words, THEY ARE BAILED OUT BY THE GOVERNMENT. But someone has to bear the negative consequences. Generally, it's the taxpayers, depositors and other creditors.
Another beautiful part of this M-LEC Superfund is that some banks will profit from the problems their industry helped create. Citigroup, a big offender (it has almost $100 billion in SIVs), J.P. Morgan and Bank of America will be paid fees for providing the financial backstop to the fund. In addition, the broker-dealer arms of the banks will be paid to handle the trading of the assets between the SIVs and M-LEC.
Bank of America emphasized the opportunity to profit during the Treasury-sponsored meetings creating the Frankensteinian M-LEC. These guys! They really know how to profit from catastrophe.
Because SIVs are off the balance sheets of the banks that created them, investors don't know exactly what their assets are or how to value them. In fact, the big banks involved in M-LEC are arguing about how to price the SIV assets. Off-balance-sheet liabilities played a major role in the 2001 collapse of Enron Corp. (remember that?)