The End of Enron Economics?

26 September, 2008

 “This is a wonderful outcome for a great number of our employees that will preserve and strengthen our terrific franchise,” - Richard S. Fuld, Jr., Chairman and Chief Executive

Officer of Lehman Brothers on the Barclay takeover.[i]

 

“The catalyst for this current crisis may be the housing market, but the larger culprit is the killing of [the] Glass-Steagall [Act], which paved the way for this recklessness.”  - Economist and former Lehman Brothers employee Nomi Prins.[ii]

 

When Enron collapsed in December 2001, thousands of employees lost their jobs and retirement savings, prompting the US Congressional Research Service to report, “The swift and unanticipated collapse of such a large corporation suggests basic problems with the U.S. system of securities regulation.”  Enron’s core business was the trading of esoteric financial instruments called “derivatives”[iii] and once again, these largely unregulated investments lie at the heart of the current US financial meltdown.

 

The next hint of “basic problems” was the bankruptcy of Lehman Brothers,[iv] whose assets and $1.45 billion of real estate holdings are being acquired by Barclay’s Capital for $250 million, and a $500 million operating loan.[v]  Shortly afterwards, the US Federal Reserve announced an $85 billion rescue for American International Group (AIG.) 

 

This follows Bear Sterns and two Government Sponsored Enterprises (GSE), Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), whose bailouts may cost taxpayers $900 billion.[vi]  And now Goldman Sachs and Morgan Stanley, the last two remaining investment banks, are restructuring as commercial banks.[vii]  Does this mean the end of Enron economics?

 

Behind this capitalist catastrophe is the mixing of commercial banks that provide public banking services, and investment banks that underwrite securities for corporations.  If the two are linked, the holding company can exert pressure on the commercial bank to make loans using the investment bank’s risky securities as collateral.[viii]

 

The Glass-Steagall Act of 1933, passed in the aftermath of the 1929 stock market crash, prohibited commercial banks from underwriting securities.  Pushed by the Reagan administration, the Federal Reserve eased Glass-Steagall restrictions in 1987 despite objections by Chairman Paul Volker.[ix]  In 1999, Congress yielded to lobbying by financial interests and repealed the law, thus eliminating these safeguards.[x]

 

Defaults on US subprime mortgages, higher risk mortgages granted to people with lower credit ratings,[xi] initiated the current crisis in early 2005.[xii] Concern was minimal until August 2007, when US and European banks became alarmed at the difficulty of valuing their holdings of derivatives collateralized by subprime mortgages.[xiii]  Valuing derivatives was also a core issue in the Enron collapse.[xiv]

 

Derivatives are contracts that derive value from other financial instruments such as stocks, bonds, commodities, interest rates or mortgages.[xv]  The simplest mortgage derivatives are Mortgage Backed Securities (MBS), bonds backed by pools of similar mortgages, whose interest and principle payments are passed on to investors.  The US government guarantees GSE-issued MBSs, but those issued by the private sector are not,[xvi] and by 2006, 71% were backed by subprime mortgages.[xvii]

 

Next in complexity are Interest Only/Principle Only (IO/PO) derivatives.  An IO derivative passes on interest payments from the underlying MBS bond whereas a PO derivative passes on principle payments.  Both alter the risks involved, for suppose the MBS is paid off in a year.  A $100,000 PO purchased at a discount for $60,000 would pay the full principle for a 66.7% return, while a $100,000 IO with an interest rate of 5% would only pay $5,000.[xviii]  In financial parlance, the IO derivative has higher prepayment risk than the PO.  Both derivatives have interest rate risk, should rates rise or fall, and also default risk if mortgage borrowers are unable to make payments.

 

More complicated are Collateralized Mortgage Obligations (CMO), derivatives prioritized by principle payoff.  Derivatives in the first priority group or “tranche” are paid off first, then those in the second are paid off and so on, but all tranches receive interest payments.  The first tranche has the least default risk; the last tranche has the most.  Varying interest rates and principle distribution among the tranches creates a wide range of risks to suit the “risk appetites” of investors. Collateralized Mortgage Backed Securities (CMBS) are similar to CMOs but are even more convoluted.

 

The process begins when an originator creates a mortgage and sells it to either a GSE (44% of US mortgages) or a private sector firm (56% of US mortgages.)[xix]  The buyer collateralizes MBS bonds from pools of similar mortgages and sells them to an investment bank, which in turn sells them to an intermediary such as a trust that they have created, an Enron-style ruse to keep derivatives off the investment bank’s books.[xx]  To finance its purchase of MBSs, the intermediary packages CMO or CMBS derivatives, and sells them back to the investment bank, which markets them to investors.[xxi] 

 

In theory, this arcane financial chicanery, called “securitization,”[xxii] benefits homebuyers since the variety of risk attracts more investors thus providing more capital for mortgages.   In practice however, the complex financial instruments encourage predatory loan originators to profit by selling mortgages that borrowers are unable to afford.[xxiii]

 

The Bank for International Settlements warns, “the magnitude of the problems yet to be faced could be much greater than many now perceive.”[xxiv]   Enron economics may have ended, but Wall Street welfare continues as the US Treasury proposes multi-billion dollar bailouts for wealthy investors,[xxv] while the rest of us pay for their fiscal malfeasance.

  

Yuram Abdullah Weiler

2008-09-25

End Notes

Posted by yuram 14:14 | General , United States | Comment(0) | Permalink

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