S&L Mortgages and the Market's Fool

[mcclintockbrent%faculty%Carthage@xxxxxxxxxxxxxxxx]

A few additional thoughts to those of Doug Orr and Marshall Feldman in
response to Jason Hecht's inquiry re S&L mortgages and hedging.

S&Ls in the 1980s did engage in securitization of home mortgages on a wide
scale. Aided by the activities of Fannie Mae and Freddie Mac,  S&Ls packaged
mortgages into pools to be passed on in the form of bonds. By the late 1980s,
a growing share of housing-related assets on S&L balance sheets were not home
mortgages but these derivative securities. On paper, at least, this allowed
S&Ls to hedge part of their risk and actually boosted liquidity when the S&L
industry crashed in the late 1980s.

The problem was as Michael Lewis in _Liar's Poker_ cited in Martin Mayer's _The Greatest Ever Bank Robbery_, p. 53 points out as:
"The astute investor Warren Buffett [of Salomon Brothers fame] is fond of
saying that any player unaware of the fool in the market _is_ probably the
fool in the market.... Various Salomon mortgage traders estimate that between
50 and 90 percent of their profits derived simply from taking the other side
of thrifts trades.... What was happening -- and is still happening -- is that
the guy who sponsored the float in the town parade, the 3-6-3 member and
golfing man, had become America's biggest bond trader. He was also America's
worst bond trader. He was the market's fool."

Uncle Sam stepped in to aid the incompetent and crooked. The Federal Home Loan
Bank Board in the early 1980s changed accounting provisions for S&Ls allowing
them to sell their old low interest rate mortgages, claim a tax loss straight
away, and write off these loans over a 40 year period. S&Ls could also use the
new cash raised from securitization to make more mortgages at higher interest
rates.
Investment bankers like Salomon could take their cut too. Mayer concludes in
his book on Salomon, _Nightmare on Wall Street_, "To put it bluntly, the
profitability of the leading investment house in the world was built in the
1980s on a conspiracy against the taxpaying citizenry of the United States
organized and perpetrated by a regulatory agency and in effect confirmed by
the bipartisan Garn-St Germain Act of 1982." (p. 154)

Not that this was certain money for Salomon. Mayer suggests that on a typical
day in 1984 Salomon might be sitting on $5 billion of illiquid mortgages (more
than twice its capital) waiting to be securitized. The interest rate risk of
holding these mortgages was immense, the profits of a drop in rates huge, but
Salomon top management was in the dark about this situation in its mortgage
department. (This lack of internal management controls has repeatedly burned
major players and seems finally to be getting some attention from regulators).
In one week in 1987 Salomon blew $350 million on its mortgage securities.

The guy on Main Street was no match for the guy on Wall Street (and probably
still isn't). Since many of the derivative trades are customized, there is no
public record of trades, and no clearing system, the problems of asymmetric
information were and remain grave. Only the salesman had much chance of
knowing the profitability of these derivatives or swaps. A Salomon exec.
reflecting on this chicane, quoted by Mayer, observed: "What was going on in
that [morgtgage securitization] department ... and you think what they do to
some poor ghetto kid who steals $45."

And then there were the Charles Keatings, Ron Pauls, Don Dixons etc...

Personal teaching note: I've never seen a class get as engaged, as outraged as
when we dissect the S&L fiasco. If a politician, regulator, S&L exec, investmentbanker, accountant, appraiser, etc connected with events in the S&L industry
were to step through the door they'd be drawn and quartered! Apathy may not yet win the day...

Reading recommendations:
Martin Mayer, _The Greatest Bank Robbery Ever_ (Collier, 1990).
Martin Mayer, _Nightmare on Wall Street_ (Simon and Schuster, 1993).
Robert Sherrill, "S&Ls, Big Banks, and Other Triumphs of Capitalism," _The
Nation_, November 19, 1990, pp. 589-624.

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~|~~~~~~~~~~~~~~~~~~~~~~~~~~~|
Brent McClintock                    |                           |
Economics                           |                           |
Carthage College                    |      THERE IS NO WEALTH   |
Kenosha, Wisconsin 53140            |           BUT LIFE        |
USA                                 |                           |
Phone: (414) 551-5852               |         John Ruskin       |
Fax:   (414) 551-6208               |                           |
Internet: btm@xxxxxxxxxxxxxxxx      |                           |
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~