Last fall, I heard a senior mutual fund company executive give a talk in which he warned about the impending sub-prime disaster. I wish I’d have listened more closely. This plugged in mutual fund executive, whom I’ve known for many years had recently returned from a trip to Wall Street and Washington D.C. where he met with investment bankers and Washington lawmakers about the growing mortgage crisis (little did we know, then).
Speaking at a wealth management conference for advisors, this proactive exec made two key points. First, the traditional mortgage business had evolved into the securities business, with lenders reselling loans as fast as they could buy them up. It had quietly become a cornerstone of the investment banks to package and sell mortgages as securities products such as CDOs, CMOs, CDOs RMBS, and the rest of the alphabet soup.
Then he got down to the problem: Rising interest rates and fears of impending mortgage defaults had caused the buyers of these mortgage-backed securities to stop buying, bringing the mortgage industry to a screeching halt. His prediction: Unless the federal government–the Bush Administration and the Congress, together–took action similar to the 1930s’ Home Owner’s Loan Corporation (the New Deal entity that guaranteed defaulting borrowers and forestalled massive foreclosures), we’d face another Depression-Era meltdown on Wall Street.
Pretty good call, huh? If only I’d have paid a little more attention…But I figured that as a longtime financial services industry leader, he was a little too close to the whole subprime thing, and besides, how big could the mortgage securities market be anyway? Topple Wall Street? Get real. So it was brilliant thinking like that which led to my not acting on the executive’s prescient prediction, not getting out in front of this subprime disaster, and blowing what was undoubtedly my one chance at a Pulitzer Prize.
Ignore at Our Peril
Of course, I wasn’t the only one who ignored this insider’s sage advice: The Bush Administration and Congress come to mind. At the time of this writing, Congressional leaders and the Administration led by Treasury Secretary Henry Paulson and the Fed chair Ben Bernanke are mired in political squabbling about how best to structure a bailout package similar to the one Thornburg suggested a year ago. Although, by waiting that year, they’ve allowed Fannie Mae, Freddie Mac, Lehman Bros., Merrill Lynch, AIG, Morgan Stanley, and Goldman Sachs, among other firms, to require a bailing out, or a buying out, at a cost of additional billions of dollars. (As Senator Everett Dirksen of Illinois is reported to have said: “A billion here, a billion there; pretty soon it adds up to real money.”)
By the time you read this, hopefully the luminaries in Washington will have crafted their response. To help you and me sort out how effective this “solution” is likely to be, I’ve been trying to uncover what happened in the first place. That is, I’m looking to dig deeper than the predictable drivel we’ve gotten from the news media: greedy CEOs, underhanded mortgage brokers forcing money on unsuspecting dupes who couldn’t possibly afford those new homes, and as one economically challenged commentator succinctly captured the typical coverage recently: “There had to be some laws broken somewhere.”
Rather than cast about for someone to blame, however, it seems we’d all be better served by trying to understand what really happened so we’d have a fighting chance of fixing it now, and perhaps of seeing it coming and being able to head it off the next time. To that end, I’m puzzled about three aspects of this mess: Why did the folks actually lending the money think these loans were a good idea? How did default rates–which only recently reached 6%–topple, not only the entire mortgage market, but nearly the entire financial system? Finally, why did the investment banks–with their long, long history of schlepping bad investments to the unwary public and not-so-savvy institutions–get caught holding their own empty bag this time?
While the answers to each of these questions can be as complex as you’d like to make them, the short answer to all of them is you: the independent financial advisor. The subprime melt down is the result of Wall Street’s latest attempt to come to grips with the dramatic changes in the financial industry brought about in large part by the independent advisory movement. Unfortunately, it undoubtedly won’t be the last of such boondoggles.
The Wall Street Hijacking
To help me get to the bottom of all this, I talked to Tom Sowanick, chief investment officer at the $20 billion independent financial services firm Clearbrook Financial in Princeton, New Jersey, and the former head of Merrill Lynch’s Global Wealth Management Strategy group. Much of Sowanick’s 29 years in financial services was spent at Merrill, where he gained intimate knowledge of how Wall Street and the investment banks work. Based on that perspective, he offered some penetrating insights into the subprime meltdown and why this time, it truly was different, with the investment banks getting caught with their own pants down.
Sowanick’s first observation is that the current crisis isn’t so much a mortgage problem as it is a Wall Street crisis. Again, with default rates at 6% and foreclosures much less than that, we’re a long way from the magnitude of the Great Depression. So, while there were certainly some bad loans written, that problem isn’t bad enough to shake the whole financial system to its foundations.