Behind every great bubble and its subsequent bust lies the power of Wall Street’s trading operations. In the case of our national housing market saga and toxic subprime fallout, it’s true that banks and specialist lending institutions rapaciously extended credit to ill-equipped borrowers.
But that’s not the whole story. Housing value fluctuations weren’t just caused by lending run amok, but by the trading that enabled the lending and made a precarious situation even worse.
Regardless of whether you adopt the progressive view of the crisis (banks lured borrowers with reckless procedures) or the conservative one (borrowers should have known not to get in over their heads), lenders knew it was an easy game to lavish money and extract fees from consumers as long as they had lots of customers wanting to own the home of their dreams.
More than that, they knew they could package and sell loans to investors, indirectly through Wall Street firms, and directly, to traders, creating room on their balance sheets to originate even more mortgages. Trouble was, investor appetite for the once-lucrative sub-prime mortgage packages dried up as credit did. Investment banks that bet their client investors would be there forever got crucified and are paying the price with multi-billion dollar writedowns and ejected CEO’s. But so are homeowners, for whom every piece of bad news makes their individual financial situation seem worse.
With Citigroup’s $11 billion writedown, on top of the $2.2 billion writedown the firm had already announced in third-quarter earnings, more of that destructive news poured from Wall Street. Citigroup’s writedowns were not just due to losses resulting from borrowers defaulting on mortgage payments, but to exuberant trading on top of the mega-exuberant leveraging of those trades.
This latest writedown spelled the end of Chuck Prince’s four-year reign over Citigroup (he assumed the helm from Sanford Weill, who, with then-Treasury Secretary Robert Rubin, was instrumental in shattering the barriers imposed by the Glass-Steagall Act, the law that had kept the commercial and investment banking functions of banks separated since 1933. And in a circuitous twist of fate, Rubin, who in 1999 stepped from Treasury Secretary into the role of Citigroup’s vice chairman, has now jumped to the top of the banking hydra.
But it’s not just Citigroup’s writedown, or Merrill Lynch’s $8.4 billion one, or J.P. Morgan Chase’s nearly $2 billion one, or Wachovia’s $2.4 billion one that continue to suck the air out of the bubble they created. It’s the collective implosion of trading positions around Wall Street. And given that these are mid-earnings announcement write-downs, it’s possible more bad positions wait in the wings.
Merrill’s writedown led to the booting of CEO Stanley O’Neal, who admitted that he didn’t quite get the magnitude of impending trading losses. Wall Street traders at other houses would have been aware of it much sooner, since their own trading positions in sub-prime mortgage via CDO’s (collateralized debt obligations, the packaged loans supposedly supported by the underlying value of the assets on which their debt rests) were shrinking before them.
Traders’ bets were simple: since lenders were lending at high, or sub-prime, rates, they could buy prepackaged bunches of those loans and sell them to investors seeking to benefit from this high-payment steam. The downside risk, they calculated, was that some borrowers wouldn’t pay their mortgages and default. But, if those defaults occurred to a low enough percentage of all the mortgages in package, there would be more than enough non-defaulting loans to keep money flowing in.
And, even if defaults were happening at a quicker rate, they reasoned, surely home values would continue to rise such that any foreclosed properties could be sold back to the market at a profit. Then came the perfect storm.
Rising defaults (for lack of ability to pay, over-appraised properties and too much supply) led to a credit panic, as foreclosures began flooding the market with supply. Prices dropped, which caused less borrowing because potential borrowers were either scared, already in the market or unable to obtain new mortgages at favorable terms. Then, trading losses mounted, caused by evaluating positions based on declining mortgage payments and home values.
While politicians are focused on stricter lending practices or debating the merits of Treasury Secretary, Hank Paulson’s $100 billion Wall Street trader bail-out fund, they miss a glaring point. If lenders couldn’t offset their loans to Wall Street, their lending practices couldn’t have spiraled out of control. If Wall Street hadn’t leveraged these positions, their losses wouldn’t have brought the economic and psychological damage to the housing market that mere inability on the part of borrowers to repay their loans would have caused. There is no chance that trading limits will be imposed, and for this particular cycle, it would be too late to assuage the volatility in the housing market anyway. But greater transparency of the role of trading that created much of the housing upward and downward hysteria would go a long way to calming it the next time.