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A white paper on bank reform delivered to Congress and regulators last week by the Association of Mortgage Investors – the powerful lobbying group that represents huge institutional investors – warns that if the securitization market isn't radically reformed "it will be difficult if not impossible for capital market investors to return to funding economic activity."
What the report doesn't say is that banks – standing in the way of bank reform – don't want a simplified, standardized, and transparent securitization market, because that would revitalize free-market disciplines and undermine the control they exercise over the credit markets.
Right now, the stock market is discounting news about tight credit conditions. But analysts worry about an increasing disconnect between rallying stock prices and the hoped-for rebounds in consumer-driven growth and the U.S. housing market – both of which are struggling with a lack of access to credit. This disconnect is fostering fears of a stock-market correction.
Investors need to understand exactly what's at stake here. And they need to know how to protect themselves and – even more important – how to profit from the volatile-but-powerful capital waves that will result from this fundamental battle over our future.
Taking No Prisoners
What the big banks want is the socialization of their risk exposure and the privatization of their unbridled profitability.
And they are willing to hold the economy hostage to get it.
To achieve that goal, banks are concentrating their too-big-to-fail power so that the federal government has no choice but to backstop them – permanently lowering the cost of capital for these large lenders. And that's not all. To counteract the credit squeeze the concentration of lending power in too few banks fosters, the federal government will be forced to once-again back loan-level guarantees from privately owned, government-chartered guarantors – in other words, more government-sponsored entities (GSEs) such as Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE).
On March 23 – during a House Financial Services Committee hearing labeled as "Housing Finance: What Should the New System Be Able to Do?" – U.S. Treasury Secretary Timothy F. Geithner was questioned about the future of the biggest insolvent GSEs, Fannie and Freddie. Those two – explicitly bestowed with unlimited backing by former Treasury Secretary Henry M. "Hank" Hank Paulson Jr., have by themselves so far siphoned $165 billion from taxpayers' pockets.
Geithner told a flabbergasted panel that there were no immediate plans to unwind the entities, stating that "realistically [speaking], it's going to take several months to do a careful exploration of the problems, solutions, alternative models, and to try to shape legislation that could command consensus."
Several House members were even more disturbed when Geithner told them that "my own view is there's probably going to be a good economic case [and a] good public-policy case … for some continued provision of a carefully designed guarantee by the public sector going forward."
In short, not only are Fannie and Freddie destined to stay with us, their gross failures have elicited a very-banker-friendly fix to their troubled existence – create more of them.
Repeating Earlier Mistakes?
At the same hearing, Mortgage Bankers Association Chairman-elect Michael D. Berman proposed that a new breed of mortgage-backed securities should be structured with a federally guaranteed wrap. The association wants the government to provide an explicit credit guarantee financed by risk-based fees paid into a federal insurance fund.
The hybrid proposal – a cross between the existing government guarantee that already backs Ginnie Mae securities and the Federal Deposit Insurance Corp. (FDIC) insurance fund that covers bank deposits – came with a fresh recommendation "that regulators charter enough entities to establish a truly competitive secondary market and to overcome issues associated with too-big-to-fail."
It doesn't matter to the Mortgage Bankers Association that the Federal Housing Administration (FHA), which backs its loan-level mortgages with a government guarantee and then collects and packages those mortgages into the Ginnie Mae securities, is itself insolvent. It also doesn't matter that Ginnie Mae securities are the only mortgage-backed securities whose principal-and-interest payments to investors are 100% government-guaranteed. Nor does it matter that Ginnie Mae is stumbling down the same blind path as Fannie and Freddie.
What matters to the bankers is that they don't have to assume any risk on the mortgages they originate as long as the government guarantees them. As long as bankers can generate fees from originating loans – and then offload those loans to investors as "guaranteed" – these institutions can go back and borrow additional cheap money from the U.S. Federal Reserve and leverage their balance sheets with the very same risk-free securities. Once that's done, the banks are positioned to reap gigantic profits, pay their top executives huge bonuses – and have plenty left over to spread across Washington in order to institutionalize their latest scheme.
Outraged critics contend that regardless of whether institutions are too big to fail, or that if enough smaller institutions are afforded the same socialized model, eventual contagion resulting from systemic risk concentration and integration will kill democratic capitalism. The point is that the market is no longer allocating capital, the government is.
A Real Blueprint For Change
There is a way to break the stranglehold banks have on the economy, and at the same time arrest moral hazard and unshackle free markets.
It's simple. Congress needs to immediately enact all 10 of the recommendations called for in the Association of Mortgage Investors white paper: "Reforming the Asset-Backed Securities Market." Those 10 recommendations are:
- Provide loan-level information that investors, ratings agencies and regulators can use to evaluate collateral and its expected economic performance over the life of the securitization.
- Require a "cooling-off" period when securities are offered so that investors have time to analyze them before making investment decisions.
- Make deal documents for all asset-backed and structured securities publicly available to market participants and regulators.
- Develop standard-pooling and servicing agreements with model representations and warranties as a non-waivable industry-minimum legal standard.
- Develop clear standard definitions for securitization markets.
- Directly address conflicts of interest of servicers that have economic interests averse to those of investors.
- Require the appointment of a suitably independent and qualified trustee to act for the benefit of holders of the securities.
- Make asset-backed securities subject to private right-of-action provisions of anti-fraud statutes in securities law.
- Encourage secondary trading on venues such as exchanges where trading prices are visible to investors and regulators.
- Make ratings agencies use loan-level data in their initial ratings and to update ratings as market conditions evolve and collateral performance is reported.
Of course, banks will oppose all these recommendations for various reasons, but mostly under the guise that they are too onerous and expensive to implement and would raise the cost of capital and impede market functionality.
Self-Protection Strategies
The truth, of course, is that every one of the recommendations cuts through the opaqueness, issuer protections and marked-up fees that banks enjoy when pooling, issuing and trading their purposely complex and asymmetrically divined instruments.
We are at a critical crossroads in the evolution of capitalism. We have manufactured enough rope to hang ourselves on the gallows of socialism. With the partisan and bitter battle over healthcare momentarily behind us, and after admitting that regulatory reform should have been U.S. President Barack Obama's No. 1 agenda item when he first took office, now is the time to act decisively.
The arguments against the protective and prudent regulations that safeguard investors and the economy are always made by those with a stake in circumventing those protections for personal gain. America has an unparalleled history of creating wealth, while adapting to unforeseen and unintended consequences of both good and bad legislation, as well as the unmitigated greed of usurpers and shysters. For the sake of the republic, democratic capitalism and our economic future, it is time to empower Americans to return the country to the top of the economic world order.
Investors can help themselves on an individual level. First and foremost, I recommend you follow and actively participate in the looming regulatory battles. Write to your elected representatives, letting them know where you stand. Place stop-loss orders on all your investments: If the bankers win the regulatory-reform battle, you will get "stopped out" when the market eventually crashes. At that point, take all your capital to China, because at least there they are honest about their government-directed, socialist-economic model.
[Editor's Note: Money Morning Contributing Editor R. Shah Gilani is also the editor of the brand new Capital Wave Forecast advisory service, and is scheduled to host his first conference call with subscribers at 4 p.m. today (Tuesday).
A retired hedge-fund manager and gifted analyst, Gilani regularly takes readers behind Wall Street's "velvet rope" – and into the world he knows so well – exposing the pitfalls that can inoculate investors against ruinous losses as he highlights profit opportunities that most other experts never even recognize.
His Money Morning columns, analyses and investigative exposés have been read by millions across the Internet.
With his new advisory service – The Capital Wave Forecast – Gilani introduces investors to the "capital wave" investment strategy, identifies the monster capital waves now forming, and demonstrates how to profit from the best opportunities these powerful market forces are creating. And he doesn't ignore risk: Gilani will make certain to highlight the market pitfalls that all too often sweep investors away.
Take a moment to check out Gilani's capital-wave-investing strategy – and the profit opportunities that he's watching these waves create in key markets around the world.]
News and Related Story Links:
- Money Morning Special Investment Research Report:
How Capital Waves Are Creating the Biggest Profit Opportunities in Today's Markets - Reuters:
U.S. mortgage investor rights must be heard, group says - The Baltimore Examiner: Press Release via PRNewswire:
Statement from Micah Green On Behalf of The Association of Mortgage Investors - Investopedia:
Double-Dip Recession - Money Morning News Archive Category:
Capital Waves - Reuters:
"Too Big to Fail" in Crosshairs of Reform Debate - Wikipedia:
Too Big to Fail - Wikipedia:
Cost of Capital
- Investopedia:
Mortgage-Backed Securities - Federal Deposit Insurance Corp:
Official Web Site - Mortgage-Bankers Association:
Official Web Site - Investopedia:
Moral Hazard
- Association of Mortgage Investors White Paper:
Reforming the Asset-Backed Securities Market - WhiteHouse.gov:
Barack Obama - InvestorGlossary:
Stopped Out
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
He helped develop what has become known as the Volatility Index (VIX) - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
On top of the free newsletter, as editor of The 10X Trader, Money Map Report and Straight Line Profits, Shah presents his legion of subscribers with the chance to earn ten times their money on trade after trade using a little-known strategy.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on FOX Business' "Varney & Co."
mi found of FCDI /I DEMANDED MY FOUND
Hi Author, you DO see the pyramid scheme symbol on the back of the USA one dollar bill, right? You DO see the servitude infestation in capitalism, right? And do you see the "pay up or lose your wellbeing" Chicago mob-like felony extortion widespread within capitalism? Do you see the "join or starve" felony extortion done to the 18 year olds… by this ugly competer's church called capitalism? See how forcing competer's religions onto 18 year olds… kills membership in the cooperator's church (Christianity/socialism)?? Do you understand that AmWay (American Way) (New World Order) got "the exclusive" (legal tender) on… Read more »
GO TO NESARA,,,,NOW……..
There is no turning back from the government control so omnipresent in our economy. More regulation did nothing to prevent Bernie Madoff, Ebbers and all the other crooks who were allowed to operate despite the oppressiveness of regulations in minor ways. The campaign contributions from those with the most to lose will control how any type of legislation shakes out. Internally, the current administration and its appointees believes the whole house of financial cards will come a tumbling down without the appropriate backstops and government guarantees, and on that point they are probably right since faith in our financial system… Read more »
Rick,
I do agree that government failures occur where beaucracies rule over free enterprises. However, you comment on Maddoff surely cannot assume that this was a result of over-regulation by the government. On the contrary, all the Maddoff-hearings have clearly shown that the government was refusing to regulate even when private folks tried to bring their attention to what Maddoff was doing.
To be sure, Maddoff's and the recent sub-prime failures are not the result of over-regulation of Wall Street but rather resulted from under-regulation and eliminating (by Clinton administration) the all important Glass-Steagall Act.
Something in my education went wrong. I thought capitalism describes a system where investors take risk. Boy, was I wrong! Obviously it is the case that the capitalists direct the government what to do or not to do. The judicial system is usually accomplice to that even though once in a while a judge gives me a surprise. But then again, milking the system is easier than doing honest work. The latter is obviously what middle class people do and they are proud of it. To bad it does not get them anywhere financially. I witness how the banks curb… Read more »
The Wingnut tirade, entertaining as it is, erroneously focuses on a single aspect of the US economic system; the capitalist. Indeed that focus is further directed to the extreme edge of capitalism wherein abides the unconscionable capitalist who rightly should be castgated and expunged from the system. But there are good capitalists (Read Will Baumol's 'Good Capitalist, Bad Capitalist') who work side by side with the other half of the US economic dynamic; the entrepreneur within the free enterprise system. So whilst I can agree with Wingnut as to the greedy capitalist, let's direct our attention to him/her and put… Read more »
Hunh, and here I always thought that I was a system fighter and not a role-playing-people fighter. Well allow me to clarify. The problem with using economies and ownership… is a SYSTEMIC problem. Even if there WERE some freemasons who are still peddling "yay imperialism" pamphlets, the actual inventors of the free marketeers pyramid/order… are long dead of old age, I suspect. Its a tradition, now. A habit. A social more. An addiction. Its also "an exclusive" because only one type of coupon is accepted as legal tender. In a narrow-view way, capitalism is not the real problem, as pyramid… Read more »
Larry, Your point about declaring "get a job or die" illegal in the U.S. is very well made. To me the "get a job or die" rule is the same as the "hunt or die" rule of the natural world. Like it or not Darwin's "natural selection" is nature's version of what we are trying to socially institutionalize under the so-called "free market" capitalist system. Fortunately, we have failed so far to go to the extent that natural selection works in the natural world. The point is for society to move away from the law of the jungle and still… Read more »
Mr. Ghosh…I agree with your Darwinian theory of capitalism. We are genetically structyured to weed out the "weak" in order to improve our survival. You would have us break out of our animalistic behavior thus improving the lot of all of us. The desire is laudable, but we can't…we are alll animals (in the natural sense) and we cannot be anything else. A sad fact, but true nevertheless.
From the piece: "The point is that the market is no longer allocating capital, the government is." If the government is allocating capital, then the roles are reversed: That is, the banks are creating the money (capital) and the government allocating it. The government, as it does do, should not borrow money created by the Fed (a private corporation) and, mostly, by the banks out of thin air, when they make loans. As long as legal tender issued/created/"printed" by the governing authorities is facilitating the effective production and distribution of goods and services throughout an economy/society, then inflation is not… Read more »
As usual, another great piece from Shah Gilani. Always very insightful. While I do admire his wisdom especially related to "market failures" and "government failures" I would like to make three points in connection with his banking reforms article. One, to prevent another major failure of rating agencies to properly rate securitized mortgages we need to take the conflict of interest out of the equation. Just as in the drug industry we don't have a privately funded FDA to clear drug-sale and -use, we need a similar "toxicity rating agency" that is outside the free market institution. Such an agency's… Read more »
History shows us that we've been forewarned by our fore fathers – very early presidents that we would see such a crisis if we ever allowed the money of our working citizens to fall into the hands of a few, namely the financiers – bankers. It's our money, we work for it and earn it; we need to have control of it back! The federal reserve entity isn't even a governmental entity, contrary to what many unsuspecting Americans believe. The fact that the word federal is in the name is misleading and deceptive and is the reason many believe it's… Read more »
stop these greedy pigs worlwide