Credit where Geithner's due
Jan. 19th, 2011 01:58 pmReaders of this blog will know that in the past I have not been the greatest fan of Tim Geithner, now US Treasury Secretary. Geithner's performance during the run of 2008 disasters when he was Treasurer of the New York Fed (starting with the collapse of Bear Stearns and culminating with the collapse of Lehman Bros and bailing out of AIG and most of the other big banks/investment banks), struck me as woeful. Geithner was one of the key players in making AIG pay 100 cents on the dollar to retire its credit default swaps, when a hard negotiator could probably have got away with 55 cents on the dollar. As a result the shareholders of AIG got stuffed in order to keep all the other big US investment banks, plus not a few European investment banks, in clover.
However, Geithner's reputation is somewhat restored by the release of the transcripts of the Open Market Committee meetings in 2005.
At the February meeting in 2005 Geithner called the economic outlook at the time "implausibly benign". He added that
The "bad guy" in all of this is Alan Greenspan, who seemed incapable of seeing that the housing market was beginning to run out of control and that
For Greenspan to say that a situation was under control when construction was growing rapidly and the value of mortgages termed "sub-prime" had grown by more than 500% in five years was, well, rather optimistic.
The main problem of sub-prime was, as I wrote at the time, that the whole financial structure of small-town banking was thrown out of the window. Since any money that you lent could be "sold on", there was no need to worry about whether the money would ever be paid back. You just lent as much as you could and pocketed the commission.
The main lenders in this dubious market were Ameriquest Mortgage Co., New Century Financial Corp. and Countrywide Financial Corp, but the blame for the whole sorry affair really lies at the feet of those who decided to offer "easy money" and those who decided to carry on offering it when it became clear that things were overheating.
What was most frightening here was that virtually no-one thought they were taking a risk. And Greenspan seemed to fall for the alchemy as much as the most innnocent borrower of money that he would never be able to pay back.
How does that work?
OK:
1) Salesman in Alabama sells a $200k mortgage to a woman on $10k a year income. After three years her repayments will go up to 60% of her income, but the salesman tells himself that she'll probably be earning more by then and, if she isn't, she can just sell the house at a profit. Hell, he's really doing her a favour!
Salesman pockets $5k commission.
2) Smalltown Alabama Bank ("the Moonshiner's Friend"), which is funding the mortgage is actually just a wholesaler for Countrywide. It never assumes any of the debt. Bank pockets $5k commission and moves the debt to Countrywide.
3) Countrywide takes this mortgage, bundles it up with 500 other mortgages of various degreees of credit-worthiness, at an average interest rate of 5%, and gets in touch with Goldman Sachs.
4) Goldman Sachs takes the 500 mortgages and slices it into five tranches of Collateralized Mortgage Obligation (CMO). These are not sliced up into "100 safest, 100 next-safest" and so on. That would be far too simple. No, the "safest" tranch would be about 60-20-20-10-10, while the least safe would be something like 10-30-20-20-20. The interest offered to investors would range from, say, 3% on the "safest" tranche (even though that tranche contains a 20% proportion of subprime) and 7% on the "riskiest" tranche (which in turn contains a 10% proportion of "rock-solid" debt). Goldman Sachs sells these CMOs to pension funds, life assurance funds, etc. Goldman Sachs pockets $2m commission.
5) MetLife buys about $10m of this now sliced-and-diced debt, at an average interest rate of 4%. Effectively it now owns a varying percentage of the debt on 500 houses in Alabama, and thus a varying percentage of each of those houses should there be a default.
But MetLife doesn't want any risk on this at all. What it would like to do is insure against its investment going belly-up, but at a premium cheap enough to give it, say 3.5% interest "risk free".
6) Enter AIG Financial Products, based in London, and a classic example (see Barings), of a unit that was sending too much money back to head office (in AIG's case, in New York) for head office to enquire about whether things were genuinely okay. AIG FP offered to insure against the investments going tits up through the complicatedly named but really rather simple concept of a "credit default swap". At its heart, this meant that AIG FP got "free money", so long as none of the investments went sour. Since most of these investments were triple-A rated (see my post a few months ago about how you can magic "bad loans" into "good loans" through slicing and dicing), AIG reckoned that they were onto what was as near as you can get to a free lunch -- getting paid for taking a gamble that really wasn't a gamble at all. It charges MetLife $100k a year to insure against the $10m defaulting.
MetLife pockets $250k "free money" - that being the difference between a cash deposit and what it was earning on the $10m by buying the loans and then selling the risk.
AIG pockets $100k. It sends this back to New York. London office pockets $10k commission on the deal.
So, by the end, we have lots of salesman with $5k each, a few local banks with $500k each, Goldman Sachs with $2m, MetLife with $250k, and AIG with $100k, all out of about $50m in issued debt.
Repeat this 20 to 50 times a day.
Then the defaults start coming through, the housing market starts falling, the music stops.
Basically, all of the risk has ended up at AIGFP. It had tens of billions of dollars, in fact, probably hundreds of billions of dollars, in liabilities, all written out of an obscure outpost in London that wasn't looked at sufficiently hard because for years it sent the money back home.
This was quite enough to bring down AIG. And if AIG had been brought down, then MetLife and all of the other insurees wouldn't have got paid, which meant that their investment portfolios that had been dubbed "risk-free" would suddenly have holes in them the size of a Titanic-sinking iceberg. In cases like this, the standard strategy is to negotiate a discount on the debt, with it being decided in smoke-filled rooms who would suffer what level of pain.
All of this got shot under the water line when the Fed panicked and stepped in, guaranteeing that AIG would not fail. When as a debtor you are negotiating the "commutation" of such debts, you only have one real weapon -- the nuclear option of going broke. If the counterparties know that you won't be allowed to go broke, they have no need to accept any discount at all.
And this is what happened, and it was Geithner's fault. The only people who suffered the pain were the original AIG shareholders.
It seems odd to me that Geithner, a man who saw what was coming and warned against it, when it did come to pass, made a decision that helped those who most benefited from the "wrong" decision in 2005, while harming people (savers, shareholders) who did not.
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However, Geithner's reputation is somewhat restored by the release of the transcripts of the Open Market Committee meetings in 2005.
At the February meeting in 2005 Geithner called the economic outlook at the time "implausibly benign". He added that
"the confidence around this view, which is evident in low credit spreads – low risk premia generally – and low expected volatility, leaves one, I think, somewhat uneasy",he said at the meeting. The measured language hides what is either a clear condemnation of the Fed's strategy at the time, or is a "cover-my-arse" statement for when things go tits up (which, in 2008, they did).
The "bad guy" in all of this is Alan Greenspan, who seemed incapable of seeing that the housing market was beginning to run out of control and that
"whatever froth there is in the housing market is becoming contained at this stage".This was despite reports from Florida that construction was going mental (to the extent that drywall had to be imported from China – drywall which eventually turned out to have been rush-produced and which later proved toxic).
For Greenspan to say that a situation was under control when construction was growing rapidly and the value of mortgages termed "sub-prime" had grown by more than 500% in five years was, well, rather optimistic.
The main problem of sub-prime was, as I wrote at the time, that the whole financial structure of small-town banking was thrown out of the window. Since any money that you lent could be "sold on", there was no need to worry about whether the money would ever be paid back. You just lent as much as you could and pocketed the commission.
The main lenders in this dubious market were Ameriquest Mortgage Co., New Century Financial Corp. and Countrywide Financial Corp, but the blame for the whole sorry affair really lies at the feet of those who decided to offer "easy money" and those who decided to carry on offering it when it became clear that things were overheating.
What was most frightening here was that virtually no-one thought they were taking a risk. And Greenspan seemed to fall for the alchemy as much as the most innnocent borrower of money that he would never be able to pay back.
How does that work?
OK:
1) Salesman in Alabama sells a $200k mortgage to a woman on $10k a year income. After three years her repayments will go up to 60% of her income, but the salesman tells himself that she'll probably be earning more by then and, if she isn't, she can just sell the house at a profit. Hell, he's really doing her a favour!
Salesman pockets $5k commission.
2) Smalltown Alabama Bank ("the Moonshiner's Friend"), which is funding the mortgage is actually just a wholesaler for Countrywide. It never assumes any of the debt. Bank pockets $5k commission and moves the debt to Countrywide.
3) Countrywide takes this mortgage, bundles it up with 500 other mortgages of various degreees of credit-worthiness, at an average interest rate of 5%, and gets in touch with Goldman Sachs.
4) Goldman Sachs takes the 500 mortgages and slices it into five tranches of Collateralized Mortgage Obligation (CMO). These are not sliced up into "100 safest, 100 next-safest" and so on. That would be far too simple. No, the "safest" tranch would be about 60-20-20-10-10, while the least safe would be something like 10-30-20-20-20. The interest offered to investors would range from, say, 3% on the "safest" tranche (even though that tranche contains a 20% proportion of subprime) and 7% on the "riskiest" tranche (which in turn contains a 10% proportion of "rock-solid" debt). Goldman Sachs sells these CMOs to pension funds, life assurance funds, etc. Goldman Sachs pockets $2m commission.
5) MetLife buys about $10m of this now sliced-and-diced debt, at an average interest rate of 4%. Effectively it now owns a varying percentage of the debt on 500 houses in Alabama, and thus a varying percentage of each of those houses should there be a default.
But MetLife doesn't want any risk on this at all. What it would like to do is insure against its investment going belly-up, but at a premium cheap enough to give it, say 3.5% interest "risk free".
6) Enter AIG Financial Products, based in London, and a classic example (see Barings), of a unit that was sending too much money back to head office (in AIG's case, in New York) for head office to enquire about whether things were genuinely okay. AIG FP offered to insure against the investments going tits up through the complicatedly named but really rather simple concept of a "credit default swap". At its heart, this meant that AIG FP got "free money", so long as none of the investments went sour. Since most of these investments were triple-A rated (see my post a few months ago about how you can magic "bad loans" into "good loans" through slicing and dicing), AIG reckoned that they were onto what was as near as you can get to a free lunch -- getting paid for taking a gamble that really wasn't a gamble at all. It charges MetLife $100k a year to insure against the $10m defaulting.
MetLife pockets $250k "free money" - that being the difference between a cash deposit and what it was earning on the $10m by buying the loans and then selling the risk.
AIG pockets $100k. It sends this back to New York. London office pockets $10k commission on the deal.
So, by the end, we have lots of salesman with $5k each, a few local banks with $500k each, Goldman Sachs with $2m, MetLife with $250k, and AIG with $100k, all out of about $50m in issued debt.
Repeat this 20 to 50 times a day.
Then the defaults start coming through, the housing market starts falling, the music stops.
Basically, all of the risk has ended up at AIGFP. It had tens of billions of dollars, in fact, probably hundreds of billions of dollars, in liabilities, all written out of an obscure outpost in London that wasn't looked at sufficiently hard because for years it sent the money back home.
This was quite enough to bring down AIG. And if AIG had been brought down, then MetLife and all of the other insurees wouldn't have got paid, which meant that their investment portfolios that had been dubbed "risk-free" would suddenly have holes in them the size of a Titanic-sinking iceberg. In cases like this, the standard strategy is to negotiate a discount on the debt, with it being decided in smoke-filled rooms who would suffer what level of pain.
All of this got shot under the water line when the Fed panicked and stepped in, guaranteeing that AIG would not fail. When as a debtor you are negotiating the "commutation" of such debts, you only have one real weapon -- the nuclear option of going broke. If the counterparties know that you won't be allowed to go broke, they have no need to accept any discount at all.
And this is what happened, and it was Geithner's fault. The only people who suffered the pain were the original AIG shareholders.
It seems odd to me that Geithner, a man who saw what was coming and warned against it, when it did come to pass, made a decision that helped those who most benefited from the "wrong" decision in 2005, while harming people (savers, shareholders) who did not.
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