Mortgage crisis will be worse than S&L meltdown, by gimleteye

The Wall Street Journal is leaning toward the view I have expressed on this blog for over a year, “U.S. Mortgage Crisis Rivals S&L Meltdown.” (December 10, 2007) Here's a short discussion.

In late 1999, I walked away from the retail end of private equity management. I could not bear the corner of the financial management universe where highly paid professionals advised brokers to pitch speculation as foundational investment strategy for individuals. It was a bad time to be in that business, and I was early to conclude so: it was about to get much worse for many, many investors.

My outlook on investing had been shaped by a family manufacturing business that prospered by re-engineering winders used in textile production for more complex materials processing. Generating equity through technology and productivity improvements made sense to me: banking on ether did not.

In the early 1980’s our company skirted the edges of the DARPA technology, later called the internet. It wasn’t ready for small businesses. We paid, at the time, $90,000 for a dedicated telephone cable to link a new Wang computer system to a remote manufacturing location. Technology and productivity massively transformed the US economy in the next two decades: not even the S&L fiasco could deter the momentous shifts in equity growth.

By 1999, the S&L debacle of the late 1980’s was a sharp memory. So too was the lesson of Congress loosening regulatory burdens on lending to savings and loans. It didn’t seem possible to me that the federal government would unleash another financial bubble, to supplant the one about to burst in internet stocks.

The Wall Street Journal is clear on the nature of the change: “The current crisis… differs in crucial ways from the recent tech stock bust and the S&L crisis. For one, it centers on assets—houses—that, unlike stocks, most people have bought with borrowed money. On average, mortgage debt amounts to nearly half the value of houses. In recent years easy credit has allowed many to borrow up to the full value of their homes, making them more leverages than hedge funds… the shift of loans from banks to markets has created a staggering complexity…”

Less than a decade ago, the smoke from the decline of the Russian ruble and Latin American debt, leading to the collapse Long Term Capital Management, was just starting to clear. In the spring of 1999, my college age son, with no experience in finance or economics, looked at a chart of the stock market pointing straight up and said, 'this is going to come down isn’t it?'

As I turned off my squawk box, I could not imagine that the US government would rescue investors burned by the internet asset collapse by allowing another asset bubble in real estate. I also could not imagine how it would happen.

That's the problem with living in a neighborhood, on the ground, paying bills and taxes diligently like an ordinary mortal: it is hard enough to read between the lines of news reports that are mostly indifferent to complexity. Americans, apparently, herd easily.

Leading up to my departure from a remote Miami outpost of Wall Street, my interest in environmental issues had turned into a substantial part-time project: helping to stop the conversion of a former military base in South Miami Dade County into a privatized commercial airport, with hundreds of proposed flights a day, at the edge of two of America’s most threatened national parks: the Everglades and Biscayne National Park.

The National Environmental Policy Act, a key federal law, requires federal decisions on the use of its assets and property to take into account secondary impacts: in this case, the anticipated expansion of housing and development into important wetlands serving the bay, wilderness habitat and flood control for people.

I had been curious for some time, about the inability of public policy and law to contain suburban sprawl: a major secondary impact in this specific example.

My attention, informed by a background in investment management, turned to Fannie Mae, the quasi-governmental agency whose mortgage lending practices have played such an important role in the development industry. While most environmental organizations have been absorbed in the impossible task of prodding government agencies to hold the line with respect to baselines and environmental impacts, I was more interested in how fiscal and monetary policies of the federal government, reflected through housing and commercial construction and development, impact the environment.

Fannie Mae had been a core holding of mine, and so I was familiar—I thought—with its business. But looked at from the point of view of the environment, Fannie Mae was a disaster on several fronts. First of all, the corporation and its lending practices—with billions of assets-- was completely agnostic to considerations of the environment. Secondly, there was an utter lack of accountability to informing investors of exactly what they owned, through its massively ballooning portfolios based on securitized mortgages—or, financial derivatives.

It was called the “free market”, but it definitely was not free—as evidenced by the threats to the South Florida ecosystem where a $7.8 billion project to restore the Everglades was on a collision course with $10 billion of impacts proposed through the conversion of the Homestead Air Force Base.

And it was definitely not transparent. I did not make much progress in understanding, in depth, how the securitization of mortgages could be modified to protect threatened landscapes like those surrounding the former military base in South Miami Dade.

What I have learned in retrospect, is that the lack of transparency is a key to the smooth operation of the Growth Machine. The failure in design and implementation of laws to protect the environment, including the suppression of dissent within government agencies, is like invisible code written into the language of politics whose primary function is to serve duplicity.

By the end of 2001, the controversy over the disposal of the air base was receeding. The Bush defense department affirmed the late decision by Clinton’s to withhold permission to convert the air base for commercial aviation purposes. But if NEPA played a key role in asserting the protections due the environment from federal actions, Alan Greenspan and the Federal Reserve would provide fuel for a boom in land speculation that airport advocates hoped would occur, in the first place.

In other words, the Growth Machine didn’t need an airport—although an airport and related infrastructure would certainly serve its interests. All it needed was an opaque regulatory atmosphere and the steroids of low interest rates meant to help the economy recover from the collapse of the dot.com era.

In just a few short years--from 2001 to 2005--the rural character of South Miami Dade county turned into a sprawl-ridden mess.

According to the Wall Street Journal report, “Former Fed Chairman Alan Greenspan frequently argued there could be no housing bubble. The high cost and inconvenience of moving “are significant impediments to speculative trading and … development of price bubbles”, he said in late 2004.”

If Mr. Greenspan believed what he was saying, it can only be explained as the result of living in a bubble—cosseted by the power of fabricated statistics and an insular political elite—because by 2004, the housing market bubble had expanded to gargantuan size. Mr. Greenspan visited South Florida regularly in the winter: his perspective might have benefited from taking a helicopter flight over South Dade instead of hob-nobbing on South Beach.

To make a long story short, the Wall Street Journal serves an excellent purpose: “Mortgages today are dispersed among banks as well as more than 11,000 investment pools, each of which may have hundreds, if not thousands, of investors. Many of those pools have been further repackaged into specialized funds known as structured investment vehicles and collateralized debt obligations, or SIV’s and CDO’s—each of which have their own investors. That makes determining who owns the securities, what they are worth and the nature of the underlying collateral a trick business.”

The Journal might have added, that these financial derivatives are lightly regulated and have rained billions in commissions and fees to Wall Street.

It turns out that I was right, and more than I imagined from even the lowly worm’s eye view of the world in Miami, where Republican operatives parachuted in to steal the 2000 election from Al Gore, who speaks today on the environment without any of the blank stares that characterized his position on the Homestead Air Force Base.

We all know that to understand politics, follow the money. But in this case—of a mortgage crisis whose repercussions will dwarf the savings and loan meltdown of two decades ago—you can’t follow the money because billions—hundreds of billions—have disappeared down the rat hole of suburban sprawl dug under the disinterested eye of Congress and the White House.

There is still no discussion about how to change the equation of sprawl and of a Growth Machine that is running the U.S. economy off the rails. But the electorate is growing restive and investors are furious, as well they should be.