Toxic ARMs in 2007

Sheila Bair served as Director of Federal Deposit Insurance Corporation (FDIC) during the financially tumultuous years 2006 through 2011. She has written a book about her experience during that time of cataclysmic economic events. In Bull By The Horns, the former FDIC director gives an account of her strategy to assemble a group of financial heavy-hitters who had generated, securitized, and traded billions of dollars of low-quality home mortgages that were, in 2006-7, beginning to default in large numbers. In 2007, Sheila rounded up some subprime mortgage brokers, their money-lenders who had financed the mortgages, and representatives of the larger banks who serviced the loans after those loans had been tranched into complex Wall Street securities.

The escalating problem in 2007 centered on a large group of unqualified home-buyers who had bought into Adjustable Rate Mortgages. These mortgages began with a reasonably low interest rate with manageable monthly payments that were typically in effect for two years. But after those first two years of each mortgage, the interest rate had been contracted to balloon into a higher rate, which would enable the financiers to maintain an even greater profitable advantage. But the po' folks who were trying to pay off their new houses could not handle their newly adjusted, higher monthly payments. This turned out to be the weakest link in a chain of financial dealings that later broke in September of 2008, thereby inflicting on our economy the so-called Great Recession.

This passage from chapter 6 of Sheila Bair's book is somewhat long for a blog, but it helped me to understand what was happening behind the scenes during that time of mounting catastrophe, back in 2007. Sheila Bair writes:

"I decided that the best thing to do would be to get all stakeholders in a room together and try to hash out some type of agreement to start modifying subprime hybrid ARMs. Delinquencies on subprime hybrid ARMs were increasing quickly, and nearly half a trillion dollars' worth of such loans were scheduled to reset (to the higher interest rate, ed.) in 2007 and 2008. The answer seemed obvious: eliminate the reset and simply extend the starter rate. In other words, convert the loan into a thirty-year fixed-rate mortgage, keeping the monthly payment the same as it had been during the starter period. We thought that investors--even Triple-A investors--should support such a step. We weren't really proposing that their payments be reduced, just that they give up a payment increase that they had never had a realistic expectation of receiving. As previously discussed, hybrid ARMs were designed to force refinancings after two to three years, not to be paid at the higher rate for the life of the loan. Our data confirmed that the debt-to-income ratios on these loans were extremely high. Indeed, more than 90 percent of hybrid ARMs were refinanced at the end of the starter period. The number of borrowers who continued paying after reset was miniscule. Without some relief, subprime borrowers would default on a large scale, generating heavy losses for all bondholders, as well as the broader housing market."

As you may surmise from the subsequent implosion of our financial system in the fall of 2008, Ms. Bair's strategy of getting the mortgage players together to solve their problems hardly made a dent in the immensely complicated vortex of failing subprime mortgages. This foundational shifting sand of widespread defaults ultimately initiated a near-collapse of our financial resources and the banks who administered those funds.

Ms. Bair's attempt to guide the lenders and securitizers into corrective collaboration was a nice try, though. Surely it was a valiant effort by an exemplary, far-sighted public servant who is worthy of our respect. In the long run, however, her finger in the dyke of preventive regulation could not prevent the flood of insolvency that later debilitated our banks.

Reading her book, and particularly the above account, I was reminded of an old parable spoken long ago. In the gospel of Mark, chapter 16, we find these words from Jesus Christ:

"There was a rich man who had a manager, and this manager was reported to him as squandering his possessions.

And he called him and said to him, 'What is this I hear about you? Give and accounting of your management, for you can no longer be manager.'

The manager said to himself, 'What shall I do, since my boss is taking the management away from me? I am not strong enough to dig; I am ashamed to beg. I know what I shall do, so that when I am removed from the management people will welcome me into their homes.'

And he summoned each one of his boss's debtors, and he began saying to the first, 'How much do you owe my boss?'

And he said, ' A hundred measures of oil.' And he said to him, 'Take your bill, and sit down quickly and write fifty.'

Then he said to another, 'And how much do you owe? And he said, 'A hundred measures of wheat.' He said to him, 'Take your bill and write eighty.'

And his boss praised the unrighteous manager because he acted shrewdly; for the sons of this age are more shrewd in relation to their own kind than the sons of light.

" And I say to you, make friends for yourselves by means of the wealth of unrighteousness, so that when it fails, they will receive you into the eternal dwellings.'"

Unfortunately, our modern money managers did not similarly cut the Mortgage Backed Securities losses before exponential toxicity invaded the entire financial system. But such calamity is the story of the human race. What else is new?

Glass Chimera