Hard to imagine how far the world of finance has come. 150 years ago, we had just established a national currency, and now we have thousands of securities and derivatives to select from. In particular, CDO's catch my eye and though they were at the helm of the most recent recession, the fall of Lehman Brothers and A.I.G., these mortgage backed securities can teach us where finance is heading next. The hardest part of the equation is factoring out Freddie Mac and Fannie Mae, who package the CDOs and sell to investors.
CDO's are investment vehicles that begin with banks, which encompass many asset-backed securities, but predominately Mortgage Backed securities (MBS). Banks provide a loan for the amount of a mortgage, and place an account receivable on the books. Fannie Mae and Freddie Mac buy the loans (including principal and interest) from the banks and package them to be sold to investment banks, typically to be pooled in a mutual fund. Now, the cash that the homeowner pays flows through to the investment bank and it's mutual fund owners. Additionally, credit default swaps, a derivative, were created as a way for speculators to bet against CDO's they didn't own (which defaulted AIG).
The problems occur where banks write the loan and also where the investment banks buy the MBS. Banks should ultimately review a credit score and only loan money if their risk is mitigated. Since they are immediately guaranteed a sale of the loan, no matter what quality, subprime lending can occur. After packaging, little controls are in place with ratings agencies like Moody's and S&P. Ideally, the ratings agencies will look at each case specifically and classify into multiple categories. This did not happen during our most recent recession and many investors were fooled into thinking they had quality investments. Another problem was the lack of regulation on derivatives, which meant that no reserves were required to back credit default swaps, and proceeds were taken as bonuses.
Recently, each bank has been sued and the government (i.e. taxpayers) bailed out Freddie Mac and Fannie Mae. Fannie and Freddie, like each and every other financial institution of the time, leveraged in excess of 20 times their capital, courtesy of the SEC's April 28, 2004 vote to lift leverage limits. If they lost capital, the entire portfolio of obligations would be lost (i.e. investors lose money). 60% of the money lost came from risky investments, the remaining losses were mostly due to the lull in residential mortgages. Since many pensions and investments worldwide depend on Fannie Mae and Freddie Mac, their failure would paralyze much of the global economy.
Incredibly, Fannie and Freddie have come back in conservatorship from Sept. 2008 to now. Obama thinks the reliance on taxpayers has empowered these two to make poor judgments and have little consequence. These are For-Profit companies whose losses are repaid by the government. If backed privately, the mortgage industry would have free enterprise companies scrutinizing activities, making for an honest financial environment. In agreement with Obama, I believe more controls need to be in place. $10 Trillion in mortgages will take time to ease away from these two companies.
Currently, bi-partisan bills are being drawn for the 5 year depletion of Freddie and Fannie. Bank of America settled to pay Freddie 2.6 Billion, Citigroup settled at 400 Million, Suntrust settled at 65 Million, and Wells Fargo settled at 0.87 Billion. In any event, Dodd-Frank will keep the companies from walking the plank yet again.
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