What Were They Thinking II

So, where were we?

Well, I was off trying to do some housekeeping on this page, with a little success, I think.  Still can't get the search engines to pick it up, but I will work that out.  I am also thinking about changing the Blogspot address.  If I do, I will post the change.

When I broke the last post, my geeky guy with the platinum laptop had sold his formula to Moody's and Standard & Poor's.  

The lending institutions, as I said, knew immediately that their world had changed.  They were the first to recognize the power of AAA rated MBS paper.  Their businesses had depended on the MBS as a primary source of liquidity since the 1980s.  In that dependency they struggled continuously with its limited appeal.

By acting as a gatekeeper, the traditional MBS was the primary control on the mortgage lending process that Alan Greenspan spoke of, when he recently testified before Congress. While it was in place, it forced rigorous standards on the lending industry in qualifying borrowers and limiting leverage.

When it was lifted, with the new form, no one noticed that all traditional lending standards were lifted with it, or better said, no one wanted to notice. It was never replaced.

Greenspan's lament, widely, and wildly ridiculed in the press, deserves, I think, another consideration.  Let me first say that I know Mr. Greenspan, and at one point in my life, traveled with him extensively.  That was a long time ago and I think the distance frees me from conflict. You are free to judge.

The reason his comments are worth a re-visit is because Mr. Greenspan found it unthinkable that the operators of the market would not find ways to self regulate.  He knew them to be smart people, who should easily recognize that left out of control, any market will come to a bad end.  The very idea of finding ways to constrain market behavior within acceptable norms is an act of self preservation.

Mr. Greenspan comes from a generation of Americans that were completely comfortable accepting the concept of behavioral limits.  Where he failed was in not recognizing that the generation in control of markets at the most critical time not only didn't accept any concept of limits, but thought, and think, that the self is the only justification needed when breaking down any attempted restraint.

This generational issue is woven through the whole cloth of this mess.  The reason is something I have been observing since my college days.  

My year of birth was 1944.  That year is largely thought of as the last year counted before the fabled baby boom years began.  My observation has been that people born in my year and before tend to be fairly closely aligned with our parents generation philosophically.

Those following us, born between 1945 and 1955 have had an observable difference in their philosophy of life.  It isn't that good things have not arisen from the so-called Boomers, rather it is that along with the good have come a whole series of things that have not been good on a societal basis.

The self is the driver in this.  It is the reason you continuously run into people who act in a way that tells you that they know they are more important than you.  And that attitude invades every aspect of life.

Therefore, it should be no surprise when it shows up in business decisions.  Particularly when you realize that virtually every company involved in creating the problem was, and is, run by someone from the Boomer generation.  The surprise should be that any of them are still standing.

There are any number of children in grade school today who will earn post graduate degrees studying the detail of what happened from the moment of my geeky guy's sale to today, and beyond.  The beyond is important, because the end is not yet in sight.  The mark of when the end is in sight will be when you can call your local financial annalist and he can explain to you, in terms that you can understand, the detail in the balance sheet of J.P. Morgan, Goldman Sachs, Bank of America, or any other financial institution you want to ask about.

This little narrative is still interested in the beginning.  Large events frequently allow anyone interested in knowing, how to find the trigger point.  In our narrative, the Mood'y and Standard & Poor's change in ratings method for MBS is the trigger point.

In this mess, as with other large events, finding the trigger does not adequately explain how something seemingly small, the ratings methodology, could erupt into such a conflagration. Two broad elements involve themselves here.  The second will be described in my next post.

Finding the true beginning requires looking backward in time over things we did several decades ago.  Starting during the years of the Carter Administration, politicians, with the best of intentions, began looking at ways to build on the success of the post war programs promoting home ownership in America.

Two things were clear to them at the time.  One was that the expansion of the category of people defined as middle-class in America was the envy of the industrialized world.  The post-war growth in size, earning, and spending power of this segment of the population from 1945 to the 1970's was something never before seen.

The second thing that was clear to those well intentioned folks was that home ownership, because of its power to increase net worth over time, was statistically the largest driver in pushing people into the category.  A simple proposition occurred; find a way to get more people to be home owners and the middle class will expand even more rapidly.

That simple proposition was accepted broadly among politicians of both political parties, regionally and nationally.  It lead several successive administrations and the respective Congress to enact a combination of legislation and regulation pushing the ideal in the proposition into an obligation of the housing and lending industries.

The statistical information available supported the notion that risk, though slightly increased by the financial difference between the traditional borrowers in the statistics and some of the borrowers who would be eligible, would be acceptable.  It was frequently thought of, and described as a rounding point on the theoretical P&L statement of the lending industry.

On a direct accounting basis they had the numbers in their favor for a long time.  At least from the end of the Carter Administration, until late in the Clinton Administration.  From the last two years of Clinton, extending into the first two years of Bush, the numbers softened.

The reaction among the political class was that the softening numbers were acceptable, and probably a short term anomaly.  Their answer was to push ever harder on institutions they could control, or influence to increase, rather than reign in the expansion efforts.

The collateral effect of this is a prime part of providing the tinder that turned our small thing, the change in ratings methodology, into a conflagration.  It wasn't the only thing, as we will see in the next post, but it was significant.

The reason is another simple proposition: If you are going to expand the middle class through home ownership, you must be prepared to extend credit to weaker borrowers;  the nature of the house purchase transaction alone will increase the credit worthiness of the borrower.

The political class as a whole, believed that proposition, and to a large degree it still believes. They read the statistics as showing them to be right, and you can read in the numbers some support for the idea.  The question is what is primary, and what is ancillary.  Most who care enough to look suggest that it is ancillary.

That is, being a home owner helps increase credit worthiness because it increases net worth. The transaction itself does nothing to enhance the borrower's income, history, or instincts. Those three elements, along with the loan to value calculation on the property, are primary.

Certainly from 1998 forward, this press by the political class had the effect of building the tinder in the forest of the housing market that our trigger sent into a conflagration.  It was aided and abetted by every lender in the country when they started creating the alphabet soup of loans and securities we have seen since 2002.  

Their motivation was very different than that of the political class, but their justification for their action rose from the above.

Next: Alphabet Soup.

See you then.

What Were They Thinking

This is the first post on a brand new blog, written by an old guy.  Some believe, because of the way I think, a very old guy.  "They" may be right.

Of course, I don't think so.  Though, when I told my daughter what I wanted my granddaughter to call me, the diminutive of which is Toffy, old is in the name.  Somewhere down the road, I will tell what that means.  The only thing I will say for now is that the candy has nothing to do with the name.

So, you might ask, what is all this going to be about?  I might answer, pretty much anything I want it to be, but the real answer is those things I see as of interest to commercial and residential real estate.  Hopefully, interesting enough for both professionals and citizens.

The reason I am willing to assert myself into the swirl of things anyone can find written about real estate, is because I have been at it, and in it, for 35 years.  I am bold enough to think I might have some powers of observation, and egotistical enough to think my point of view worthwhile.

You may differ.  In the end, though, it is my blog, and that gives a certain sense of power.

To begin at the beginning, I am alarmed and disheartened about the mess we are in.  There have been endless articles published and more waiting in the queue, from word processors to printers, right now.  The coverage has ranged from pretty good, to really rank.  With a tilt to the rank side.

We seem to have moved into a time where the only two things financial writers seem to be able to construct are the naming of the one who is the guilty guy, or describing every financial event, or challenge, as if it were a horse race.  Any idea that the financial enterprise of the country is a great and immensely complex thing to observe, has been defined down so far that it makes you wonder how few are left who can even respect the size, let alone begin to describe it.

There are some, and as time goes on I will add links to those worth reading over there to the right side of this space.

Somewhere in the sea of things that make up this colossus of an enterprise, reside the commercial and residential real estate businesses.  This pair traditionally occupied places where smart people who understood risk found themselves, and made themselves comfortable within the limitations inherent in the respective parts of the businesses.

Among the limitations is a need to factor in an allowance for time.  This factor, because it defines everything you do in real estate as illiquid, curls the hair of every securities portfolio manager I have ever met.

Think about it for a moment.  Not as these businesses have been run for the last several years, but look back over the period decent statistics will let you, which is about 80 years, or so.  Over that time line, it mattered little whether you were building a skyscraper, or buying a single family house.  The requirement underlying the transaction was you needed to hold the asset in order to allow the market to prove the investment value of your decision.

Hugely diverse transactions, you say, with little in common.  Well, walk with me a little, while we suffer them a wee abstraction, and then say.

Those 80 years of data show that in America the single family house has been the best portfolio investment made by the average family over the term of their life, and the life of the data.  The data also show the value added coming over time, with the family acting out a very traditional time value of money equation.

The role of the single family house begins away from finance.  Its core capability always was in providing for a basic need, shelter, while at times enhancing lifestyle.  Meanwhile, during the holding period, the tax advantages provided through ownership reduced your actual cost of purchase, monthly.  On an after tax basis, it was as if the federal government was paying you rent for a portion of the house. 

While at the same time inflation, small, or large, meant that you paid for the house in ever cheaper dollars.  That last is rarely understood.  What it means is that as long as the house increases in value at the same rate as inflation devalues the purchasing power of the dollar, you paid out with cheaper dollars and got back whole dollars in the exchange.

In the case of the skyscraper, a similar dynamic applies, with some differences, and a burden of super risk to the developer in the initial years.  The risk is in the core capability of the building; providing office space at a reasonable rent to those who can find utility, comfort, and affordability within.

The risk to the developer is front ended into the lease-up period.  Every lease signed, on the way to lease-up, justified the risk taken on cost to construct, but did little to forecast future value.  That was in front of the developer and would come as leases rolled over, or space was vacated and re-let.

At lease-up, the transactions come back into line with each other.  The inflation issue worked to the skyscraper owner's advantage, much as with the single family house buyer.  Pay with cheaper dollars, get back whole dollars as inflation elevated the asset value.

Something else wonderful also happened to the skyscraper builder.  Every month the tenants in the building would take out their checkbooks and write a check for the rent required to hold and use the space that they occupied. 

Through that rent the tenants paid the mortgage, and the operating expenses, and the taxes, not the owner.  That implies that this owner got not only what the single family house buyer did, but because of the rent exchange, paid the costs with infinitely cheaper dollars.  

If you want to see what the exchange of rent money for space did, go get a rate sheet on a 20 year mortgage, showing principal and interest over the term.  Run your finger down until you see the principal balance owing after 10 years.  I won't keep you in the dark, principal would reduce by more than a third over the first ten years of the loan.

These were inherently good transactions within the body of the colossus of the economy.  They were never the leaders.  They always were followers of what else was going on in the monster. This for very logical reasons. 

The general economy had to deliver the income to the single family house buyer, before he could qualify for the mortgage to make the purchase.  Likewise, the general economy had to deliver the business expansion necessary to create the demand for the space within the skyscraper.

I should say, before going on that there are any number of other factors and risks in each of the sample transactions referred to here.  My focus on the risk of time is for a purpose, which, if you are still reading, will show in a moment.

I said above that there are roughly 80 years of good statistics tracking transactions similar to ours.  They show steady lines of growth in home ownership and office building consumption. There are out years, or bad years, of course, but the lines slope upward on any chart that lays them out.  Underlying the upward slope is a constant return, with seeming little risk, that makes the compounding return on equities seem small.

When you add the leverage available to real estate as a class, compared with equities, normal returns become a superheated possibility.  The problem: the lack of liquidity.

This is where we found ourselves in the late 1990's.  It was the same place that I found in the late 1960's, when I first entered the real estate and financial services world.  Remember those portfolio managers with the curled hair?  Those fellows, as a group, precede me forever, enviously looking at the possibilities in the returns on real estate, but without any means to get over the problem of liquidity.

Several things happened over time that changed things, and brought us to today.  The first of those was a fellow named Michael Milken.  Not the Michael Milken, who went to jail, but his earlier self.  The one who figured out a financial formula that allowed those portfolio managers to take comfort in raising their portfolio returns through the purchase of low rated, or junk bonds.

Milken's formula did not work in real estate, but it did work.  Any number of those portfolio managers made a lot of money following his advice.  That served to whet their appetite for the next geeky guy coming out of nowhere with a formula for something else.  

Any number of them did, and you can track their emergence through the rise of the modern American hedge fund industry.  This crowd grew from a few practitioners of arcane theories in counterpoint to modern portfolio theory, in the 1980's, to a heard of debt loving, math driven, roulette players, today.

As sometimes happens, when real estate's geeky guy first appeared, not many noticed.  The reason was the appearance was through a sleepy little device called a Mortgage Backed Security, or MBS, for short.  

In its simplest form, a Mortgage Backed Security is a bond like instrument, secured as to principal and interest by a pool of notes, which in turn are secured by a pool of mortgages, issued in favor of the note holders, by the borrowers under the notes. 

Throughout the 1990's the term sleepy applied, because of industry practice both at the loan origination level, and at the pooling, or securities level.  Underwriting standards were rigorous, the default rate on the notes very low, and the coupon return high when compared with other instruments providing similar risk.  

This area of real estate investment remained relatively the same straight through the day 3000 of our fellow citizens were murdered.  In the aftermath of that most foul day, several things changed in the operation of our financial colossus.  The first was the reduction in interest rates begun with the Federal Reserve cutting overnight lending rates to 1%.  Longer rates eased, but not as much as some hoped.

By the time we got to mid 2002, it was clear that a combination of slightly easier long rates, with very low short term rates, and massive liquidity within lending institutions, had begun to stimulate the economy, and with it an interest in both residential and commercial real estate.

Housing prices began to recover.  New construction started to expand.  The demand for mortgages increased.  With the increased demand for mortgages, the institutions originating the loans increased the demand for the creation of MBS.  That was simple business for the loan originator, because the MBS was the tool they used to sell the loans they created, make a profit on the effort, and renew the pool of funds available for lending.

The gate keeper on the process was the sleepy nature of the MBS itself.  These securities had limited appeal.  Once issued, they rarely traded, rather they were bought and held by a set number, and type of institution that both understood and could use them.  They, like the real estate underneath of them, produced handsome returns, but were very much illiquid.

Then, and there, entering from stage left as if directed by Orson Wells, came the geek from nowhere.  This was the fellow long sought by my portfolio manager friends with the curled hair. 

Under his arm was a platinum cased laptop computer that contained the formula.  The Rosetta Stone, that which would unlock all of those extraordinary returns seen in real estate.  The device that would provide the ever before unthinkable, liquidity.  

The very device that would cause so many people to lose their souls.  The only single device that I have seen in my lifetime capable of completely flummoxing our financial colossus.

Contained on the hard drive of that platinum cased laptop, was a financial formula.  The geeky guy who created it pitched it to a number of people and institutions, and in the doing he may have made himself the greatest single salesman in the history of the country.

That moment of doing came when he succeeded in selling his genius creation to Moody's Investors Service and Standard & Poor's.  What he sold them was the pure alchemy of turning investment dross into gold.

The specific he sold them was the re-ordering of the sleepy old MBS, decoupling it from the idea of investment security in the strength of the pool.  Instead, he persuaded them to look at what happens if your investment is not in the pool, but in a position in the line of payment from the pool.  The same inventory of notes and mortgages would justify a higher rating value were you positioned in the front of the line of payment rather than in the middle, or the back end.

The justification for his theory was the same 80 year data, where you find default rates very low.  The fact that the data were taken from a lending experience that was changing as the sale of the theory was being made was not considered.  The sale was made and the AAA rated MBS was born.

The lending institutions knew immediately that having an ability to feed their work product, the original loans, into a highly rated MBS was a game changing event for them.  The gatekeeper on MBS volume was removed.  The challenge no longer was in how to sell the loans and reclaim liquidity, but what to do to increase the number of loans for sale.

Meeting the challenge was easy, broaden the market by making the loans available to more people.  Ease standards slightly and the number of potential borrowers increased dramatically. The easing would slightly diminish the credit value of the pool supporting the MBS, but that consideration went away the moment the sale of the MBS converted from buying the pool, to buying a position in the line of payment.

This is the moment when the mess we are in began.  I am also at the moment where I am going to break this first post.  I want to see what this thing looks like when published and that means tweaking the page some before posting.  More later.

In the mean time, as an old friend was fond of saying "Stand by to repel boarders."