Fannie and Freddie were the most regulated institutions in the world. They had there own agency devoted to regulating them with several hundred employees. The regulator failed under Clinton just as it did under Bush, so this isn't an issue of politics.

Regulation in not a panacea because the regulators have a massive incentive to become corrupt, or more likely to just look the other way and worry about their personal lives more than their regulatory duties. Think about it, you are a government employee making maybe $70k a year working 40 hours a week and surfing the net all day. You have little or no real responsibilities other to look over the shoulder of a company. If you go with the flow you keep your cushy job with no risk to your well being. Where is the incentive?

The political heads of the various departments have near zero authority over the employment status of the bureaucracy, so they do as they please.

As a career soldier I can call a spade a spade. We have a guy who graduated in the bottom 10 of his Naval class and still went to flight school. Flight school in the military is reserved for the academic best unless your father is an admiral. Flying, with a lack of aptitude most certainly resulted in his POW status. This POW status has been the center piece of his political career. Not his education or his ability, not his judgment nor his integrity, its been his POW status.

We have a gal who received a cash award from being runner up as Ms. Alaska and used the money to go to college earning a degree in journalism. Her popularity in beauty contests later served to get her elected. For those who believe in melding church and state and establishing laws based on the moral values of your religion I can see how Palin could be an attractive choice but I have been to countries where religion rules the government.

------------------------------------

What few people ever seem to get is that the problems we are dealing with starts with the front line people making the mortgage loans. Professionally, I am one of these quants from a mortgage investment company that has gone belly-up.

The fact is that with no/low document loans, the entire financial system was relying on those people to feed us loans that had the same relative risk of the loans they had fed us in the past, everything else being equal — credit scores, LTVs, borrower incomes, etc.

But guess what, when mortgage rates started to move up and the prime market started to slow, these guys started to fudge the loans they were making. Want a better rate on your investment property? I'll put down that it will be your primary residence instead, that'll cut 1/2 percent. Need an appraisal at $250,000, when it reasonably should be $200,000? I'll find you the right appraiser — wink, wink, nod, nod. And so on.

I've worked it out with my colleagues. Historically, it takes at least 6-9 months to tell that a mortgage deal is starting off poorly, maybe 12-15 months. The REALLY bad subprime loans started in late 2005. My firm caught on in mid-2006. We started running numbers, looking for the reasons. Months ticked by. It was the end of the year and we had our five culprits. Loan characteristics that never appear on the computer files shared by loan sellers AND SO WERE NEVER IN THE MODELS. We built an add-on to our model for 2007, but too late we were sunk. What we'd already bought in 2006 and the market reaction to S&P and Moody's horrendous management of their rating actions destroyed the market and us.

Wall Street greed? Yes, they (we) were enablers of fraud by the front line mortgage brokers getting their $2000 per loan pumped into the system. But do you expect the head of a street mortgage shop go to his boss in 2005 and say, "Mr. O'Neal/Mr. Fuld/Mr. Whoever, there is too much risk in my business line (although the data doesn't show it yet). Fire my entire mortgage group."

-------------------------------------

What do you suppose would have happened if someone had gone to Mr. Fuld (or whatever) and said: "You need to understand that because the origination process does not provide me with adequate data, I cannot do what I'm supposed to be doing?" It'd be more like Don Rumsfeld's "known unknowns." Just wondering.

---------------------------------------

C'mon people! Wake up, nobody sees the proverbial 800 pound gorilla…

The quants didn't invent these products. They were just asked by mgmt to justify the decision to securitize the loans to housekeepers. These junior (Chinese or Russian) guys are fresh from a math or physics program and have no clue about what a mortgage is and the local economy of CA or FL.

The experienced sales guy who"ll reap the 7-figure bonus knows exactly though what he's doing when he's stuffing the securities to the investors and saying "our quants have used a very conservative 2% default rate and, anyway, two rating agencies say it's AAA".

The rating agencies are of course accomplice; they have their own clueless quants too and have never changed default assumptions since the 80s but they'll reap the hundred thousands of dollars to rate the bonds of ONE cdo.

The accountants are part of the game too. They'll tell the trader "yeah, you bought the bond and you have also bought insurance against its default from a AAA counterparty, you can therefore book the 20-year profit right now instead of waiting that long — go claim your multimillion bonus and here's our invoice" (so called "negative basis trade").

That's what is at the crux of this mess but how come nobody talking about the gorilla in the room?????

----------------------------------------

"I think the underlying current is that these firms and their senior decision makers have had a blind faith in their risk models, the one exception being Goldman Sachs. Clearly, the traders and senior management at Goldman know that computer models designed by PhD grads are still no substitute for experience and sound judgment."

My take-away is somewhat different. The difference at Goldman is that management asked the quants to build models that reflected reality to the best of their ability, while in most cases the staff was required to build models that reflected the business model (illusions) some manager wanted to use, knowing that short-term gains would yield them rich rewards. Search the page for "Goldman" and you'll find this.

This isn't a rocket science event like LTCM. What happened was a long housing price boom fueled the sort of abuses common to such events. Several levels of participants were motivated (by greed) to game the system, canceling the checks that normally prevent you or me from buying a house and defaulting, from a 200K property from getting a 250K mortgage, from a B security being sold as AA and so on. At higher levels it was more abstract and the information less clear. But the fraud at street level wasn't secret; it was encouraged, perhaps indirectly created by the next level up and so forth, because the securities were meant to be held briefly and passed along. It was a multiplayer virtual reality version of the old pyramid scheme.

-------------------------------------

Three short observations:

1. It makes no sense to ridicule the intelligence of people who walked away from this debacle with billions of dollars.

2. For at least 20 years, responsible economists and journalists have bemoaned the level of US debt; be it personal, governmental or foreign exchange. And yet the solution to every financial hiccup has been to encourage even more debt though lower interest rates, and other mechanisms.

3. BearStearns, Freddie and Fannie, AIG, etc were deemed "too large to be allowed to fail". But the solutions so far have mostly encouraged the formation of even larger entities that are by definition "too large to be allowed to fail". It seems to me that the opinion expressed by the Economist magazine makes more sense. If a monster company must be bailed out with tax payers money, then that company should be outright nationalized;
its debt and assets should be rationalized, and then it should be broken into smaller pieces (which are not too big to be allowed to fail) and sold back to the private sector, to recover some of the tax payer money. Also, perhaps in the name of national security, no merger or acquisition should be allowed if the resulting entity would be deemed "too large to be allowed to fail".

--------------------------------------

Well, folks, fundamentally speaking, the pen is mightier than elbow grease. We now live in a world where no productivity is needed to justify creation of currency units, ie money! Ah, money…a unit of exchange, of storage, of value, etc..The intellectual basis for this crisis is that we have decided to prioritize the symbolic aspect of money, thereby eliminating the need for real production to back up the creation of new value. It used to take a buck's skin to make a dollar. Now, we just need a dollar. Long on dollars? Go short, make up to two out of one! Garbage ideas in the minds of garbage persons yields resplendent garbage. Has anyone figured out what Jeb Bush's role over at the Lehmann Brothers Estate sale is to be, and how much he is being paid for his alleged expertise?

----------------------------------

"Isn't it strange that these 100 year events seem to be occurring every 10 years."

I have also been in the situation of voicing an unpopular conclusion to a very bullish management team (incidentally of a firm that dabbles in commercial mortgages). Initially they were thankful for the heads-up when they were only minor problems that could be fixed within the quarter. As larger and larger issues piled up that would affect our annual guidance, I was sidelined more and more and ultimately ignored for asking very reasonable questions and voicing legitimate concerns. I was also shocked by our board of directors at their lack of curiosity in all of this. We just went with more (ridiculous) optimistic assumptions to get to where management thought we should be. Ultimately I have been proven correct but will of course not receive the credit. There isn't a whole lot anyone can do when the management team is stubborn, and will not listen to reason, risk models, or anyone else.

The point being, management teams are not stupid, they know exactly what they are doing. They have every incentive of taking outsized risks because they know they will be lavishly rewarded in the short-run, and still well-taken care of in the long-run (through golden parachutes, or just the next lucrative offer elsewhere) regardless of the outcome. For most companies that just go belly-up, it's the employees and shareholders that suffer, but at least the damage is contained, they all at least had an idea of their exposure to incompetence.

But for the really BIG screw-ups that get bailed out (AIG, Fannie, Freddie, LTCM), the management teams should all face serious jail time for financial fraud on a massive scale. No exaggeration, that is exactly what they were doing, they knew it all along and didn't care, and should face the consequences, especially now that public funds are being used to support their fraudulent behavior. NOT FINES, they have more than enough money to pay their way out of this, but actual time in a federal prison, that is the only way to scare them straight, so that others won't take those same sorts of risks in the future.

-------------------------------------

There are two large, unmentioned elephants in this discussion.

1. Mathematical models really can't fully encompass, explain, and more or less predict reality;

2. When the broad markets use roughly the same mathematical premises as the basis of their proprietary models, the behavior of the market participants becomes positively correlated, not diversified, as a result of which the markets move in unison; thus, when the sell lights go on, they go on in more or less every trading room, there's a rush to the exits, and eventually a big pile of bodies at the door.

What really happened here is that 12-15 years ago, the financial world bought a bunch of magic beans–various models, chiefly Value at Risk–that they believed could so accurately measure risk that they could take more chances, reserve less against losses, and make more money.

The problem: These were models–not reality–and models can only anticipate a finite number of events, while reality has a nasty habit of surprising you with the unexpected. The financiers were told the models should be used as only one input to decision-making–not the decision-making process itself–but nobody listened; over time, the verdict of the models became god-like.

VaR's fundamental mistake: It's based on the idea of perfect liquidity–anything can be sold at some price– whereas when markets freeze up, there is no liquidity. And since most risk management models are built on VaR, they all reacted the same way last August to the plunge in sub-prime-related bonds–they all flashed sell signals. But since everybody was selling, there was no liquidity–only that pile of bodies at the exits.

This reminded everybody about all the weak models in their own shops, and likewise reminded them that there was nothing special about their shops, or their portfolios: That most shops' portfolios had similarly weak models, and most everybody's portfolios were salted with the results.

Since everybody knew they now had no idea of what their own portfolios were worth, it was reasonable to conclude nobody else did, either. This meant there was no more guarantee their counterparties could perform in a pinch, than there was that they themselves could perform, considering the reality that no shop knew what their own portfolios were worth.

It also reminded them that pretty much every financial asset, worldwide, had been priced off VaR-based models since it took such deep root in the markets. And that while they didn't know what these assets were worth, it was only common sense that they were worth less than the risk-adjusted price at which they'd been bought.

Ergo, no market confidence, evaporated liquidity, and frozen credit markets–and today's headlines.

And need I mention that most of the derivatives market falls into this description?

The worst part of all this is that while no one knows what anything is worth, what follows close behind is that virtually all financial assets, world wide, need to be re-priced downwards, and that there is no mechanism available to any central bank to manage an event like that: It just has to wash through the system, with the logical results.

And who's to blame for all this? Nobody. Pogo said it best: "We have met the enemy, and he is us." This is one case where everybody is to blame. And we're all going to have to pay for believing in magic beans.

Cheery prospect, ain't it?

-------------------------------------

The Private Securities Litigation Reform Act, while not a major cause, is something I have not seen mentioned anywhere. The corporate political machine convinced everybody that securities fraud plaintiffs lawyers were fleecing investors and that legislature should raise the pleading standards for securities class actions - as a result, it became much harder to bring successfully leverage a bona fide class action complaint into a meritorious settlement. The number of filings and the average settlements went down. The government did just stop enforcing the securities laws; it decommissioned the private attorney generals out there who were doing a great job of making it very expensive to defraud the American people.

--------------------------------

"McCain voted in favor of this deregulation. Joe Biden and every other democratic senator voted against it."

1. Actually, McCain did not vote for Gramm-Leach-Bliley (GLB), he was on the campaign trail at the time of the vote, so we will never know his position.

2. Joe Biden did vote for GLB, as did Harry Ried, who is also out claiming that GLB is the heart of the problem.

3. Leach, the L in GLB, is an advisor to the Obama campaign.

4. In any case GLB passed 90-8 in the Senate on 11/4/1999, the House passed it 362-57, and Bill Clinton signed it into law.

If GLB has anything to do with today's problems, and I know of no evidence to support the theory, it is a bipartisan creation.

------------------------

I think the reasons for mass failures of financial institutions in developed world are:
1. Agency issues:
a. Rewarding somebody immediately for creating a long-term liability for an institution. In ideal world, the reward payout plan should reflect the term of liability.
b. BIS II regime, which allows banks to calculate their own capital requirement
2. Regulator Failures
a. Investment Banks have an incentive to create new markets (read CDS and other derivatives) and keep those markets away from public regulation. It is a job of a regulator to bring transperancy and efficient "entity neutral" price finding and settlement systems in a new every market which finds wide acceptance
b. Unified regulation of entities playing across multiple traditional roles of commercial banks, investment banks and insurers
c. All financial market regulators needed to be subservient to the monetary policy (Central Banking) authority
3. Lack of Financial Planning
a. If one has short-term funding, one needs to have short-term assets of equivalent maturity, currency and size. An institution which hopes to create wealth by riding yield curve is doomed to fail
b. Control on Leverage. The leverage of institution should be such that the instition should have capital remaining after a synchronized adverse 6-sigma movement in its entire portfolio. (If we can achieve 6-sigma quality in physical world, why we cannot create financial institutions with 6-sigma survival chances, and still make money)

-------------------------------------

September 30, 1999

Fannie Mae Eases Credit To Aid Mortgage Lending

By STEVEN A. HOLMES

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

The action, which will begin as a pilot program involving 24 banks in 15 markets -- including the New York metropolitan region -- will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring.

Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates -- anywhere from three to four percentage points higher than conventional loans.

''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ''Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.''

Demographic information on these borrowers is sketchy. But at least one study indicates that 18 percent of the loans in the subprime market went to black borrowers, compared to 5 per cent of loans in the conventional loan market.

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''

Under Fannie Mae's pilot program, consumers who qualify can secure a mortgage with an interest rate one percentage point above that of a conventional, 30-year fixed rate mortgage of less than $240,000 -- a rate that currently averages about 7.76 per cent. If the borrower makes his or her monthly payments on time for two years, the one percentage point premium is dropped.

Fannie Mae, the nation's biggest underwriter of home mortgages, does not lend money directly to consumers. Instead, it purchases loans that banks make on what is called the secondary market. By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings.

Fannie Mae officials stress that the new mortgages will be extended to all potential borrowers who can qualify for a mortgage. But they add that the move is intended in part to increase the number of minority and low income home owners who tend to have worse credit ratings than non-Hispanic whites.

Home ownership has, in fact, exploded among minorities during the economic boom of the 1990's. The number of mortgages extended to Hispanic applicants jumped by 87.2 per cent from 1993 to 1998, according to Harvard University's Joint Center for Housing Studies. During that same period the number of African Americans who got mortgages to buy a home increased by 71.9 per cent and the number of Asian Americans by 46.3 per cent.

In contrast, the number of non-Hispanic whites who received loans for homes increased by 31.2 per cent.

Despite these gains, home ownership rates for minorities continue to lag behind non-Hispanic whites, in part because blacks and Hispanics in particular tend to have on average worse credit ratings.

In July, the Department of Housing and Urban Development proposed that by the year 2001, 50 percent of Fannie Mae's and Freddie Mac's portfolio be made up of loans to low and moderate-income borrowers. Last year, 44 percent of the loans Fannie Mae purchased were from these groups.

The change in policy also comes at the same time that HUD is investigating allegations of racial discrimination in the automated underwriting systems used by Fannie Mae and Freddie Mac to determine the credit-worthiness of credit applicants.