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Good Reading -- September 2010

An overdue and extra-long edition -- hope you enjoy.


Facts and Figures

  • (Part I) The average pay for hourly workers (constituting 80% of the work force) in recent recessions, adjusted for inflation:

  • mid-'70s: fell 6%

  • early-'80s: fell 3%

  • '90-'91: fell 2%

  • Dec. '07 - present: increased 5%

  • (Part II) After being acquired by Terra Networks for $12.5 billion in 2000 and then by Daum Communications in 2004 for just $95 million, Lycos has now been sold to Ybrant Digital for less than half that at $36 million.

  • (Part III) I'd like to think this email as the positive exception...

  • Email eats a quarter of the working day... "a diary study of people in various different occupations they found that on average, people spent 23% of their working day dealing with email. One study has found that workers are managing an average of 65 tasks in 10 different spheres at any one time. And we often react quickly to incoming email, almost like the phone ringing. One workplace study found that 70% of emails were reacted to within 6 seconds of their arrival, and 85% within 2 minutes. The problem is that it took participants in the same study 64 seconds to recover their train of thought after an email interruption. Add this to the fact that Gonzalez & Mark (2004) have found that people spend an average of only 3 minutes on each task before they switch to another, and it's difficult to see how anyone can achieve the psychological state of 'flow' necessary for complex tasks."


  1. "Planned Economy or Planned Distruction" -- an editorial cartoon from the Chicago 1934. History may not repeat itself, but it rhymes.

  2. "Letting Go" -- more from my favorite doctor, Atul Gawande. This isn't really relevant to investing, business or even healthcare reform, but it's excellent and thought-provoking as always. Warning: not exactly light bed-time reading.

  3. Ruane, Cunniff and Goldfarb Investor Day Transcript -- lots of worthwhile thoughts from some great value investors. (Email me if you'd like to read 2009's edition too).

  4. "The Singular Henry Singleton" -- I came across a great profile from Forbes magazine in 1979 of the brilliant engineer and investor Henry Singleton, who gets high praise from many notable people (Buffett included). A quick look at his record will reveal why. Teledyne is a tremendous case study in capital allocation, among other things.

  5. "Overview of Distressed Debt Investing" -- a helpful presentation if you're entirely new to the topic. If not, there are a lot of pretty charts. Page 18 in particular has a particularly interesting snapshot of just how little we have delevered overall (i.e., how much pain is left to go).

Special Housing Finance/GSE Section

  1. "The Future of Housing Finance" (pasted at bottom) -- I've spent a lot of time harping on the GSEs, so here is a great op-ed that actually proposes feasible, intelligent solutions. Correctly pointing to the source of the problem (HUD's affordable housing mandates of the early and mid-1990s) that mushroomed over time, the author correctly surmises: "While the road to housing hell may have been paved by the government, the road back will be built by the private sector." He adds: "The goals should be larger down payments, stricter underwriting standards...and the removal of affordable housing mandates. If there is to be an affordable housing policy, it should not be implemented by hidden subsidies and loose lending standards, but instead made transparent and funded on budget by the government."

  2. "Subprime 2.0 is Coming to a Neighborhood Near You" (pasted at bottom) -- a more recent column from Mr. Pinto. I love the recommedation at the end: "As a society, we have to go back to at least 20 percent down, with limited exceptions. Credit histories need to be solid. Documentation has to be iron-clad. Lender capital levels need to be raised. Here’s my proposal to bring Congress’s penchant for imprudent lending to a quick end: All congressional pension assets should be invested in funds backed solely by the high- risk loans mandated by federal housing legislation. I have a feeling that things would change fast."

  3. "Government Housing Policies in the Lead-up to the Financial Crisis: A Forensic Study" (big file -- available upon request) -- a long but exceptionally good study conducted by Mr. Pinto. It's a big file, so I don't want to clog everyone's email, but let me know if you want a copy.

  • Note: After I wrote about the first item above, I had the pleasure of meeting Mr. Pinto in our offices a few weeks ago. Over an hour or two he expanded on these topics, and he is the real deal. Of all the reading I've done on the topic, Mr. Pinto is the only person I've found who understands the financial, policy, and mortgage- and housing-industry specific issues and how they are interconnected. A lot of people understand one or two components of the issue, but if you want the go-to source for both detailed analysis and thoughtful integration of details into the big picture, Mr. Pinto is your guy.


  1. "I Love Gold" -- a good summary of the gold market right now.

  2. "The 20 Richest People of All Time" -- I can't vouch for completeness or accuracy, but this is an intersting attempt to rank the 20 richest people in history in inflation-adjusted dollars. Certainly there is a bias toward past few centuries (money was pretty hard to measure/compare in the pharoahs' days), but with all of the deserved talk of income inequality lately, I think it's interesting to note how much comparative wealth was concentrated in so few (mostly monopolistic hands) in prior generations, particularly in the late 19th and early 20th century. Of this list, only Carlos Slim (#20), Buffett (#19) and Gates (#6) are still alive. Also note that Buffett and Gates are giving away essentiallyall of their money during their lifetimes, and that if this were adjusted from peak to current wealth, Gates would be down near the bottom with Buffett.

  3. "The Bears and the State of Housing" -- NYT columnist David Leonhardt raises a good question here: Do you see housing as a luxury good or a staple? Obviously the answer is somewhere in between (except for those who are super rich or very poor), but it's a useful way of framing the outlook for housing. (And I do think the question is whether to be more bearish or less bearish.) I also agree that the housing market ranks behind (un)employment, budget deficits, trade deficits, consumer debt, and several other problems (education and health care, to name two) that deserve national policy attention. Either way, I will always argue to individuals that housing is a relatively poor investment; a home is primarily a place to live, not a wealth generator.

  • The graphic charting expenditures as a per cent of households' budgets since 1930 is also very interesting. Is it any wonder we're fat? And wow, scary to think about quickly health care has gone from the bottom to the top of the list.

  1. Burry, Predictor of Mortgage Collapse, Bets on Farmland, Gold -- I agree that:

  • there is a disturbing and complete lack of accountability for the housing crisis from top to bottom;

  • that the current housing market is artificially propped up;

  • that sustainable agricultural properties might be a good allocation of capital in coming years and decades;

  • that past and present policies are not useful in preventing the next catastrophe;

  • that Fannie and Freddie have been co-opted as special purpose vehicles used to implement [futile, possibly counterproductive] government policy

  • that we would be best served if the government (gradually) got out of the housing market entirely;

  • and that the current Wall Street model of proprietary trading/investing is rife with conflicts of interest and should be severely curtailed.

But I still disagree about gold's usefulness for anything other than jewelry.

Copied Below

  1. "How Will You Measure Your Life" -- great thoughts on thinking about "resource allocation" from a personal perspective.

  2. "For Fannie Stock, Even Betting Pennies is a Risk" -- please forward this to any remaining proponents of the Efficient Markets Hypothesis.

  3. "You Made More This Year than Fannie Made Since 1970" -- note that 1970 marked Fannie's IPO, and its loss of $58 billion in 2008 more than erased its cumulative profits from 1970 through 2007. "Chart of the Day" is attached.

  4. "Bad Debts Rise As Bust Erodes Home Equity" -- anybody else interested in restoring the concept of debtors' prison? Obviously "it's not the homeowner's fault that the value of the collateral drops," but then it can't be the banks' fault either. And it is the homeowner's fault for signing his name to a ridiculous loan he couldn't possibly afford and using the proceeds to buy cars and boats and flat screen TVs. I don't buy the "predatory lender" angle in home equity loans in the vast majority of cases -- these people were outspendig their means, pure and simple. This supposedly professional real estate agent who "doesn't want to be a slave to the bank" wants a pity party because his massively levered bet on multiple properties blew up in his face? This false sense of entitlement just has to end if we're ever going to get out of this whole mess...

  5. "Physics Envy in Finance" -- excellent points on the intrinsic weaknesses of financial modeling and risk management from Rick Bookstaber, of all people.

  6. "Lou Simpson Retiring from Geico" -- his age was the only thing keeping him from being named the outright successor to Buffett as CIO.

How Will You Measure Your Life?

by Clayton M. Christensen

Don’t reserve your best business thinking for your career.

Editor’s Note: When the members of the class of 2010 entered business school, the economy was strong and their post-graduation ambitions could be limitless. Just a few weeks later, the economy went into a tailspin. They’ve spent the past two years recalibrating their worldview and their definition of success.

The students seem highly aware of how the world has changed (as the sampling of views in this article shows). In the spring, Harvard Business School’s graduating class asked HBS professor Clay Christensen to address them—but not on how to apply his principles and thinking to their post-HBS careers. The students wanted to know how to apply them to their personal lives. He shared with them a set of guidelines that have helped him find meaning in his own life. Though Christensen’s thinking comes from his deep religious faith, we believe that these are strategies anyone can use. And so we asked him to share them with the readers of HBR.

Before I published The Innovator’s Dilemma, I got a call from Andrew Grove, then the chairman of Intel. He had read one of my early papers about disruptive technology, and he asked if I could talk to his direct reports and explain my research and what it implied for Intel. Excited, I flew to Silicon Valley and showed up at the appointed time, only to have Grove say, “Look, stuff has happened. We have only 10 minutes for you. Tell us what your model of disruption means for Intel.” I said that I couldn’t—that I needed a full 30 minutes to explain the model, because only with it as context would any comments about Intel make sense. Ten minutes into my explanation, Grove interrupted: “Look, I’ve got your model. Just tell us what it means for Intel.”

I insisted that I needed 10 more minutes to describe how the process of disruption had worked its way through a very different industry, steel, so that he and his team could understand how disruption worked. I told the story of how Nucor and other steel minimills had begun by attacking the lowest end of the market—steel reinforcing bars, or rebar—and later moved up toward the high end, undercutting the traditional steel mills.

When I finished the minimill story, Grove said, “OK, I get it. What it means for Intel is...,” and then went on to articulate what would become the company’s strategy for going to the bottom of the market to launch the Celeron processor.

I’ve thought about that a million times since. If I had been suckered into telling Andy Grove what he should think about the microprocessor business, I’d have been killed. But instead of telling him what to think, I taught him how to think—and then he reached what I felt was the correct decision on his own.

That experience had a profound influence on me. When people ask what I think they should do, I rarely answer their question directly. Instead, I run the question aloud through one of my models. I’ll describe how the process in the model worked its way through an industry quite different from their own. And then, more often than not, they’ll say, “OK, I get it.” And they’ll answer their own question more insightfully than I could have.

My class at HBS is structured to help my students understand what good management theory is and how it is built. To that backbone I attach different models or theories that help students think about the various dimensions of a general manager’s job in stimulating innovation and growth. In each session we look at one company through the lenses of those theories—using them to explain how the company got into its situation and to examine what managerial actions will yield the needed results.

On the last day of class, I ask my students to turn those theoretical lenses on themselves, to find cogent answers to three questions: First, how can I be sure that I’ll be happy in my career? Second, how can I be sure that my relationships with my spouse and my family become an enduring source of happiness? Third, how can I be sure I’ll stay out of jail? Though the last question sounds lighthearted, it’s not. Two of the 32 people in my Rhodes scholar class spent time in jail. Jeff Skilling of Enron fame was a classmate of mine at HBS. These were good guys—but something in their lives sent them off in the wrong direction.

As the students discuss the answers to these questions, I open my own life to them as a case study of sorts, to illustrate how they can use the theories from our course to guide their life decisions.

One of the theories that gives great insight on the first question—how to be sure we find happiness in our careers—is from Frederick Herzberg, who asserts that the powerful motivator in our lives isn’t money; it’s the opportunity to learn, grow in responsibilities, contribute to others, and be recognized for achievements. I tell the students about a vision of sorts I had while I was running the company I founded before becoming an academic. In my mind’s eye I saw one of my managers leave for work one morning with a relatively strong level of self-esteem. Then I pictured her driving home to her family 10 hours later, feeling unappreciated, frustrated, underutilized, and demeaned. I imagined how profoundly her lowered self-esteem affected the way she interacted with her children. The vision in my mind then fast-forwarded to another day, when she drove home with greater self-esteem—feeling that she had learned a lot, been recognized for achieving valuable things, and played a significant role in the success of some important initiatives. I then imagined how positively that affected her as a spouse and a parent. My conclusion: Management is the most noble of professions if it’s practiced well. No other occupation offers as many ways to help others learn and grow, take responsibility and be recognized for achievement, and contribute to the success of a team. More and more MBA students come to school thinking that a career in business means buying, selling, and investing in companies. That’s unfortunate. Doing deals doesn’t yield the deep rewards that come from building up people.

I want students to leave my classroom knowing that.

Create a Strategy for Your Life

A theory that is helpful in answering the second question—How can I ensure that my relationship with my family proves to be an enduring source of happiness?—concerns how strategy is defined and implemented. Its primary insight is that a company’s strategy is determined by the types of initiatives that management invests in. If a company’s resource allocation process is not managed masterfully, what emerges from it can be very different from what management intended. Because companies’ decision-making systems are designed to steer investments to initiatives that offer the most tangible and immediate returns, companies shortchange investments in initiatives that are crucial to their long-term strategies.

Over the years I’ve watched the fates of my HBS classmates from 1979 unfold; I’ve seen more and more of them come to reunions unhappy, divorced, and alienated from their children. I can guarantee you that not a single one of them graduated with the deliberate strategy of getting divorced and raising children who would become estranged from them. And yet a shocking number of them implemented that strategy. The reason? They didn’t keep the purpose of their lives front and center as they decided how to spend their time, talents, and energy.

It’s quite startling that a significant fraction of the 900 students that HBS draws each year from the world’s best have given little thought to the purpose of their lives. I tell the students that HBS might be one of their last chances to reflect deeply on that question. If they think that they’ll have more time and energy to reflect later, they’re nuts, because life only gets more demanding: You take on a mortgage; you’re working 70 hours a week; you have a spouse and children.

For me, having a clear purpose in my life has been essential. But it was something I had to think long and hard about before I understood it. When I was a Rhodes scholar, I was in a very demanding academic program, trying to cram an extra year’s worth of work into my time at Oxford. I decided to spend an hour every night reading, thinking, and praying about why God put me on this earth. That was a very challenging commitment to keep, because every hour I spent doing that, I wasn’t studying applied econometrics. I was conflicted about whether I could really afford to take that time away from my studies, but I stuck with it—and ultimately figured out the purpose of my life.

Had I instead spent that hour each day learning the latest techniques for mastering the problems of autocorrelation in regression analysis, I would have badly misspent my life. I apply the tools of econometrics a few times a year, but I apply my knowledge of the purpose of my life every day. It’s the single most useful thing I’ve ever learned. I promise my students that if they take the time to figure out their life purpose, they’ll look back on it as the most important thing they discovered at HBS. If they don’t figure it out, they will just sail off without a rudder and get buffeted in the very rough seas of life. Clarity about their purpose will trump knowledge of activity-based costing, balanced scorecards, core competence, disruptive innovation, the four Ps, and the five forces.

My purpose grew out of my religious faith, but faith isn’t the only thing that gives people direction. For example, one of my former students decided that his purpose was to bring honesty and economic prosperity to his country and to raise children who were as capably committed to this cause, and to each other, as he was. His purpose is focused on family and others—as mine is.

The choice and successful pursuit of a profession is but one tool for achieving your purpose. But without a purpose, life can become hollow.

Allocate Your Resources

Your decisions about allocating your personal time, energy, and talent ultimately shape your life’s strategy.

I have a bunch of “businesses” that compete for these resources: I’m trying to have a rewarding relationship with my wife, raise great kids, contribute to my community, succeed in my career, contribute to my church, and so on. And I have exactly the same problem that a corporation does. I have a limited amount of time and energy and talent. How much do I devote to each of these pursuits?

Allocation choices can make your life turn out to be very different from what you intended. Sometimes that’s good: Opportunities that you never planned for emerge. But if you misinvest your resources, the outcome can be bad. As I think about my former classmates who inadvertently invested for lives of hollow unhappiness, I can’t help believing that their troubles relate right back to a short-term perspective.

When people who have a high need for achievement—and that includes all Harvard Business School graduates—have an extra half hour of time or an extra ounce of energy, they’ll unconsciously allocate it to activities that yield the most tangible accomplishments. And our careers provide the most concrete evidence that we’re moving forward. You ship a product, finish a design, complete a presentation, close a sale, teach a class, publish a paper, get paid, get promoted. In contrast, investing time and energy in your relationship with your spouse and children typically doesn’t offer that same immediate sense of achievement. Kids misbehave every day. It’s really not until 20 years down the road that you can put your hands on your hips and say, “I raised a good son or a good daughter.” You can neglect your relationship with your spouse, and on a day-to-day basis, it doesn’t seem as if things are deteriorating. People who are driven to excel have this unconscious propensity to underinvest in their families and overinvest in their careers—even though intimate and loving relationships with their families are the most powerful and enduring source of happiness.

If you study the root causes of business disasters, over and over you’ll find this predisposition toward endeavors that offer immediate gratification. If you look at personal lives through that lens, you’ll see the same stunning and sobering pattern: people allocating fewer and fewer resources to the things they would have once said mattered most.

Create a Culture

There’s an important model in our class called the Tools of Cooperation, which basically says that being a visionary manager isn’t all it’s cracked up to be. It’s one thing to see into the foggy future with acuity and chart the course corrections that the company must make. But it’s quite another to persuade employees who might not see the changes ahead to line up and work cooperatively to take the company in that new direction. Knowing what tools to wield to elicit the needed cooperation is a critical managerial skill.

The theory arrays these tools along two dimensions—the extent to which members of the organization agree on what they want from their participation in the enterprise, and the extent to which they agree on what actions will produce the desired results. When there is little agreement on both axes, you have to use “power tools”—coercion, threats, punishment, and so on—to secure cooperation. Many companies start in this quadrant, which is why the founding executive team must play such an assertive role in defining what must be done and how. If employees’ ways of working together to address those tasks succeed over and over, consensus begins to form. MIT’s Edgar Schein has described this process as the mechanism by which a culture is built. Ultimately, people don’t even think about whether their way of doing things yields success. They embrace priorities and follow procedures by instinct and assumption rather than by explicit decision—which means that they’ve created a culture. Culture, in compelling but unspoken ways, dictates the proven, acceptable methods by which members of the group address recurrent problems. And culture defines the priority given to different types of problems. It can be a powerful management tool.

In using this model to address the question, How can I be sure that my family becomes an enduring source of happiness?, my students quickly see that the simplest tools that parents can wield to elicit cooperation from children are power tools. But there comes a point during the teen years when power tools no longer work. At that point parents start wishing that they had begun working with their children at a very young age to build a culture at home in which children instinctively behave respectfully toward one another, obey their parents, and choose the right thing to do. Families have cultures, just as companies do. Those cultures can be built consciously or evolve inadvertently.

If you want your kids to have strong self-esteem and confidence that they can solve hard problems, those qualities won’t magically materialize in high school. You have to design them into your family’s culture—and you have to think about this very early on. Like employees, children build self-esteem by doing things that are hard and learning what works.

Avoid the “Marginal Costs” Mistake

We’re taught in finance and economics that in evaluating alternative investments, we should ignore sunk and fixed costs, and instead base decisions on the marginal costs and marginal revenues that each alternative entails. We learn in our course that this doctrine biases companies to leverage what they have put in place to succeed in the past, instead of guiding them to create the capabilities they’ll need in the future. If we knew the future would be exactly the same as the past, that approach would be fine. But if the future’s different—and it almost always is—then it’s the wrong thing to do.

This theory addresses the third question I discuss with my students—how to live a life of integrity (stay out of jail). Unconsciously, we often employ the marginal cost doctrine in our personal lives when we choose between right and wrong. A voice in our head says, “Look, I know that as a general rule, most people shouldn’t do this. But in this particular extenuating circumstance, just this once, it’s OK.” The marginal cost of doing something wrong “just this once” always seems alluringly low. It suckers you in, and you don’t ever look at where that path ultimately is headed and at the full costs that the choice entails. Justification for infidelity and dishonesty in all their manifestations lies in the marginal cost economics of “just this once.”

I’d like to share a story about how I came to understand the potential damage of “just this once” in my own life. I played on the Oxford University varsity basketball team. We worked our tails off and finished the season undefeated. The guys on the team were the best friends I’ve ever had in my life. We got to the British equivalent of the NCAA tournament—and made it to the final four. It turned out the championship game was scheduled to be played on a Sunday. I had made a personal commitment to God at age 16 that I would never play ball on Sunday. So I went to the coach and explained my problem. He was incredulous. My teammates were, too, because I was the starting center. Every one of the guys on the team came to me and said, “You’ve got to play. Can’t you break the rule just this one time?”

I’m a deeply religious man, so I went away and prayed about what I should do. I got a very clear feeling that I shouldn’t break my commitment—so I didn’t play in the championship game.

In many ways that was a small decision—involving one of several thousand Sundays in my life. In theory, surely I could have crossed over the line just that one time and then not done it again. But looking back on it, resisting the temptation whose logic was “In this extenuating circumstance, just this once, it’s OK” has proven to be one of the most important decisions of my life. Why? My life has been one unending stream of extenuating circumstances. Had I crossed the line that one time, I would have done it over and over in the years that followed.

The lesson I learned from this is that it’s easier to hold to your principles 100% of the time than it is to hold to them 98% of the time. If you give in to “just this once,” based on a marginal cost analysis, as some of my former classmates have done, you’ll regret where you end up. You’ve got to define for yourself what you stand for and draw the line in a safe place.

Remember the Importance of Humility

I got this insight when I was asked to teach a class on humility at Harvard College. I asked all the students to describe the most humble person they knew. One characteristic of these humble people stood out: They had a high level of self-esteem. They knew who they were, and they felt good about who they were. We also decided that humility was defined not by self-deprecating behavior or attitudes but by the esteem with which you regard others. Good behavior flows naturally from that kind of humility. For example, you would never steal from someone, because you respect that person too much. You’d never lie to someone, either.

It’s crucial to take a sense of humility into the world. By the time you make it to a top graduate school, almost all your learning has come from people who are smarter and more experienced than you: parents, teachers, bosses. But once you’ve finished at Harvard Business School or any other top academic institution, the vast majority of people you’ll interact with on a day-to-day basis may not be smarter than you. And if your attitude is that only smarter people have something to teach you, your learning opportunities will be very limited. But if you have a humble eagerness to learn something from everybody, your learning opportunities will be unlimited. Generally, you can be humble only if you feel really good about yourself—and you want to help those around you feel really good about themselves, too. When we see people acting in an abusive, arrogant, or demeaning manner toward others, their behavior almost always is a symptom of their lack of self-esteem. They need to put someone else down to feel good about themselves.

Choose the Right Yardstick

This past year I was diagnosed with cancer and faced the possibility that my life would end sooner than I’d planned. Thankfully, it now looks as if I’ll be spared. But the experience has given me important insight into my life.

I have a pretty clear idea of how my ideas have generated enormous revenue for companies that have used my research; I know I’ve had a substantial impact. But as I’ve confronted this disease, it’s been interesting to see how unimportant that impact is to me now. I’ve concluded that the metric by which God will assess my life isn’t dollars but the individual people whose lives I’ve touched.

I think that’s the way it will work for us all. Don’t worry about the level of individual prominence you have achieved; worry about the individuals you have helped become better people. This is my final recommendation: Think about the metric by which your life will be judged, and make a resolution to live every day so that in the end, your life will be judged a success. > July–August 2010

For Fannie Stock, Even Betting Pennies Is a Risk

August 4, 2010, 6:04 pm

It is flotsam of the housing wreck, a stock no longer worthy of the Big Board. But penny by penny, the mortgage giant Fannie Mae is being salvaged in the stock market, The New York Times’s David Gillenreports.

Nearly two years after it was effectively nationalized, Fannie Mae has become the nation’s hottest penny stock — and, perhaps, its most dangerous. Even though the shares are almost worthless, they are changing hands at a furious pace. Since June, about 31 million of them have been traded on a typical day, more than triple the average for Goldman Sachs shares.

All those Fannie Mae shares do not add up to much money. The stock closed at 40 cents on Wednesday, about the cost of a first-class postage stamp. In mid-2007, before the housing market deflated, it fetched nearly $85.

“The volumes are astonishing,” said Bose T. George, a financial analyst at Keefe Bruyette & Woods “It’s like a casino.”

The knockdown price partly explains why Fannie Mae typically ranks among the liveliest financial shares in the market: It doesn’t cost much to take a flier on Fannie.

But the Lilliputian price also explains why Fannie Mae might have buy-and-hold types feeling queasy. A penny or two change in the price translates into a big move in percentage terms. Last week, for instance, Fannie Mae’s shares jumped 47 percent one day, only to sink 14 percent the next.

Behind all of this commotion are day traders, those creatures of the dot-com era. Mutual funds and other institutions have mostly abandoned Fannie Mae, as well as shares of its cousin Freddie Mac. The big money has ceded the marketplace to individuals who are bold enough, or perhaps foolish enough, to gamble on these stocks for a few hours.

Just don’t hold Fannie Mae too long, Mr. George advised. He predicted the stock would eventually fall to zero. It is difficult to know what other analysts think, since Mr. George is just about the only one who still covers Fannie Mae’s stock. His recommendation is an understated “underperform” — Wall Street code for sell.

“It’s not really a stock anymore — everyone knows this is going to zero,” he said.

Well, not everyone, at least not right away. But the running interest in Fannie Mae’s stock might seem surprising, considering that this company was the Titanic of the mortgage market. During the bubble years, Fannie Mae and Freddie Mac bought up so many toxic mortgages that the government was forced to take them over. Their stock prices promptly plunged.

The federal government today owns almost 80 percent of Fannie and Freddie, and few people, in Washington or on Wall Street, seem to know what to do with them.

Despite the trading frenzy, Fannie and Freddie have become pariahs. Most big investors won’t touch them. As of March 31, Fannie’s shareholders included two big money management companies, the Vanguard Groupand BlackRock. But together they owned a mere 1.2 percent of the company, a pittance given the size of those investment companies.

Big institutions typically sell if a stock price sinks below $5. Fannie Mae has not traded that high in two years. Last month, both Fannie Mae and Freddie Mac were ignominiously tossed off the New York Stock Exchangebecause their share prices had languished below $1 for more than 30 days straight.

And so the once-mighty Fannie Mae and Freddie Mac have been banished to OTC Bulletin Board, home to lowly penny stocks and thinly traded “microcap” companies. As the Securities and Exchange Commission says in its guide for investors: “Investors in penny stocks should be prepared for the possibility that they may lose their whole investment.”

The question of what to do with these troubled giants vexes policy makers and bankers alike. Together, Fannie Mae and Freddie Mac own or guarantee roughly half of the nation’s $11 trillion home mortgage market. The new overhaul of financial regulation did nothing to address the companies, even though they played a central role in inflating the housing bubble.

The Obama administration plans to hold a conference on the future of housing on Aug. 17 to seek advice about reforming the rules governing mortgage finance. The goal is to deliver a proposal to Congress by January.

What that proposal will say is anyone’s guess. Fannie and Freddie’s harshest critics want the companies shut down. But even banking executives concede that, for now, the federal government will probably have to play some role in mortgage finance, given the industry’s dependence on Fannie and Freddie.

“The fundamental problem with Fannie and Freddie is that no one really knows what to do with them,” said Bert Ely, a financial and monetary policy consultant based in Alexandria, Va., and a longtime critic of the companies. Until Washington comes up with answers, the day traders will no doubt try to ride the swings in Fannie Mae and pocket some more pennies while they still can.

You Made More This Year Than Fannie Since 1970: Chart of Day

2010-08-05 04:00:15.0 GMT

By Brendan Moynihan

Aug. 5 (Bloomberg) -- House Financial Services Committee Chairman Barney Frank, who begins drafting legislation next month to overhaul Fannie Mae and Freddie Mac, said in 2003 the mortgage companies were "financially sound." How wrong was he?

The CHART OF THE DAY shows Fannie Mae’s cumulative profit since going public in 1970. In 2008 alone, the company lost $58 billion, erasing its cumulative profit as a publicly traded company. In 2009, it lost $72 billion more.

Frank’s challenge will be to create an entity that serves the goal of making housing more affordable without the conflict of interest of being driven by shareholder returns.

Republicans may highlight Frank’s past support for the government-sponsored agencies. The Massachusetts Democrat said seven years ago of Fannie Mae and Freddie Mac: "We see entities that are fundamentally sound financially and withstand some of the disaster scenarios. . ." and ‘‘I want to roll the dice a little more in this situation towards subsidized housing.’’

The government-backed mortgage giants were placed in conservatorship in September 2008 and are now 80 percent owned by U.S. taxpayers. They own or guarantee more than half of the nation’s $11 trillion in residential mortgages. Fannie Mae and Freddie Mac have an unlimited line of credit from the government and have so far cost U.S. taxpayers $145 billion, more than American International Group Inc.

--Editors: Chris Nagi, Nick Baker

To contact the reporter on this story:

Brendan Moynihan in Brentwood, Tennessee, at +1-312-519-5372 or

To contact the editor responsible for this story:

Nick Baker at +1-212-617-5919 or

Bad Debts Rise As Bust Erodes Home Equity

2010-08-12 07:51:55.657 GMT

By DAVID STREITFELD; John Collins Rudolf contributed reporting.

Aug. 12 (New York Times) -- PHOENIX -- During the great housing boom, homeowners nationwide borrowed a trillion dollars from banks, using the soaring value of their houses as security.

Now the money has been spent and struggling borrowers are unable or unwilling to pay it back.

The delinquency rate on home equity loans is higher than all other types of consumer loans, including auto loans, boat loans, personal loans and even bank cards like Visa and MasterCard, according to the American Bankers Association.

Lenders say they are trying to recover some of that money but their success has been limited, in part because so many borrowers threaten bankruptcy and because the value of the homes, the collateral backing the loans, has often disappeared.

The result is one of the paradoxes of the recession: the more money you borrowed, the less likely you will have to pay up.

"When houses were doubling in value, mom and pop making $80,000 a year were taking out $300,000 home equity loans for new cars and boats," said Christopher A. Combs, a real estate lawyer here, where the problem is especially pronounced. "Their chances are pretty good of walking away and not having the bank collect."

Lenders wrote off as uncollectible $11.1 billion in home equity loans and $19.9 billion in home equity lines of credit in 2009, more than they wrote off on primary mortgages, government data shows. So far this year, the trend is the same, with combined write-offs of $7.88 billion in the first quarter.

Even when a lender forces a borrower to settle through legal action, it can rarely extract more than 10 cents on the dollar.

"People got 90 cents for free," Mr. Combs said. "It rewards immorality, to some extent."

Utah Loan Servicing is a debt collector that buys home equity loans from lenders. Clark Terry, the chief executive, says he does not pay more than $500 for a loan, regardless of how big it is.

"Anything over $15,000 to $20,000 is not collectible," Mr.

Terry said. "Americans seem to believe that anything they can get away with is O.K."

But the borrowers argue that they are simply rebuilding their ravaged lives. Many also say that the banks were predatory, or at least indiscriminate, in making loans, and nevertheless were bailed out by the federal government. Finally, they point to their trump card: they say will declare bankruptcy if a settlement is not on favorable terms.

"I am not going to be a slave to the bank," said Shawn Schlegel, a real estate agent who is in default on a $94,873 home equity loan. His lender obtained a court order garnishing his wages, but that was 18 months ago. Mr. Schlegel, 38, has not heard from the lender since. "The case is sitting stagnant," he said. "Maybe it will just go away."

Mr. Schlegel's tale is similar to many others who got caught up in the boom: He came to Arizona in 2003 and quickly accumulated three houses and some land. Each deal financed the next. "I was taught in real estate that you use your leverage to grow. I never dreamed the properties would go from $265,000 to $65,000."

Apparently neither did one of his lenders, the Desert Schools Federal Credit Union, which gave him a home equity loan secured by, the contract states, the "security interest in your dwelling or other real property."

Desert Schools, the largest credit union in Arizona, increased its allowance for loan losses of all types by 926 percent in the last two years. It declined to comment.

The amount of bad home equity loan business during the boom is incalculable and in retrospect inexplicable, housing experts say. Most of the debt is still on the books of the lenders, which include Bank of America, Citigroup and JPMorgan Chase.

"No one had ever seen a national real estate bubble," said Keith Leggett, a senior economist with the American Bankers Association. "We would love to change history so more conservative underwriting practices were put in place."

The delinquency rate on home equity loans was 4.12 percent in the first quarter, down slightly from the fourth quarter of 2009, when it was the highest in 26 years of such record keeping.

Borrowers who default can expect damage to their creditworthiness and in some cases tax consequences.

Nevertheless, Mr. Leggett said, "more than a sliver" of the debt will never be repaid.

Eric Hairston plans to be among this group. During the boom, he bought as an investment a three-apartment property in Hoboken, N.J. At the peak, when the building was worth as much as $1.5 million, he took out a $190,000 home equity loan.

Mr. Hairston, who worked in the technology department of the investment bank Lehman Brothers, invested in a Northern California pizza catering company. When real estate cratered, Mr.

Hairston went into default.

The building was sold this spring for $750,000. Only a small slice went to the home equity lender, which reserved the right to come after Mr. Hairston for the rest of what it was owed.

Mr. Hairston, who now works for the pizza company, has not heard again from his lender.

Since the lender made a bad loan, Mr. Hairston argues, a 10 percent settlement would be reasonable. "It's not the homeowner's fault that the value of the collateral drops," he said.

Marc McCain, a Phoenix lawyer, has been retained by about 300 new clients in the last year, many of whom were planning to walk away from properties they could afford but wanted to be rid of -- strategic defaulters. On top of their unpaid mortgage obligations, they had home equity loans of $50,000 to $150,000.

Fewer than 5 percent of these clients said they would continue paying their home equity loan no matter what. Ten percent intend to negotiate a short sale on their house, where the holders of the primary mortgage and the home equity loan agree to accept less than what they are owed. In such deals primary mortgage holders get paid first.

The other 85 percent said they would default and worry about the debt only if and when they were forced to, Mr. McCain said.

"People want to have some green pastures in front of them,"

said Mr. McCain, who recently negotiated a couple's $75,000 home equity debt into a $3,500 settlement. "It's come to the point where morality is no longer an issue."

Darin Bolton, a software engineer, defaulted on the loans for his house in a Chicago suburb last year because "we felt we were just tossing our money into a hole." This spring, he moved into a rental a few blocks away.

"I'm kind of banking on there being too many of us for the lenders to pursue," he said. "There is strength in numbers."

Monday, August 16, 2010

Physics Envy in Finance

This represents my personal opinion, not the views of the SEC or its staff. If all you have is a hammer... I read a New York Times article a while ago on econophysics – the use of the tools of physics in economics – that featured the application of seismology to solve the problems of market crises. I can see the twists of logic that led to this approach: during an earthquake things shake around and fall, and during a market crisis things shake around and fall. Seismology predicts the former, so why not the latter?

This type of logical leap too far is nothing new. I remember the popularity of Kalman filters and the application of the principles of torque to measure the strength of market turns (I’m not kidding) in the seventies. Later came the emergence of chaos theory to model market dynamics and catastrophe theory to model market breaks, the logic being that markets look chaotic, and that market breaks are, well, breaks.

None of these work, and as I will get to in a bit, there is a reason they don’t work. But the use of physics in finance and economics persists, thus the fledgling discipline of econophysics. The reason it persists is first of all, that there are not many jobs for physicist in physics, and most of finance is child’s play once you have gone through the rigors of a physics degree, so a lot of physicists end up in finance. Another reason is that most of those in finance really do have physics envy. They want to have the solid structure, the clean answers, and the sexy mathematical models of physics.

So if you are a physicist by training, what is more natural than to take to your new home with your physics hammer, especially if everyone wants you to look at everything as if it is a nail.

Boards don’t hit back

Andrew Lo and Mark Meuller have has a recent paper that addresses the issue of physics envy. They focus on the applicability of the tools of physics as the type of uncertainty becomes more profound, pointing out that while physics can generate useful models if there is well-parameterized uncertainty, where we know the distribution of the randomness, it becomes less useful if the uncertainty is fuzzy and ill-defined, what is called Knightian uncertainty.

I think it is useful to go one step further, and ask where this fuzzy, ill-defined uncertainty comes from. It is not all inevitable, it is not just that this is the way the world works. It is also the creation of those in the market, created because that is how those in the market make their money. That is, the markets are difficult to model, whether with the methods of physics or anything else, because those in the market make their money by having it difficult to model, or, more generally, difficult for others to anticipate and do as well.

In the Bruce Lee movie, Enter the Dragon, Lee faces his arch enemy in a fight. To intimidate Lee, his opponent holds up a board, and splits it in two with his fist. Lee watches passively and says, “Boards don’t hit back”. That gets to the reason physics does not work in finance: markets do hit back.

The markets are not physical systems guided by timeless and universal laws. They are systems based on creating an informational advantage, on gaming, on action and strategic reaction, in a space without well structured rules or defined possibilities. There is feedback to undo whatever is put in place, to neutralize whatever information comes in.

The natural reply of the physicist to this observation is, “Not to worry. I will build a physics-based model that includes feedback. I do that all the time”. The problem is that the feedback in the markets is designed specifically not to fit into a model, to be obscure, stealthy, coming from a direction where no one is looking. That is, the Knightian uncertainty is endogenous. You can’t build in a feedback or reactive model, because you don’t know what to model. And if you do know – by the time you know – the odds are the market has changed. That is the whole point of what makes a trader successful – he can see things in ways most others do not, anticipate in ways others cannot, and then change his behavior when he starts to see others catching on.

For example, I have seen this issue repeatedly in risk management, and it is one reason any risk management model will not cover all the risks. Once the risk model is specified, the traders will try to find a way around it. Are you measuring DV01 risk? Well, fine, then I will do DV01-neutral yield curve trades. Now are you measuring yield curve risk? Fine, then I will do DV01 and yield curve neutral butterfly trades. One of the problems with VaR – and for that matter with any complex model – is that it opens up all the more dimensions for such gaming, and for gaming in a way that is harder to detect. Maybe this can be put into a model, but if it can, it won’t look like how things are modeled in physics.

So it is not by chance that there are so many people trying to add complexity to the markets. Whatever rules are put in place, whatever metrics are devised, traders will try to find ways around them. In an engineering system, if you find a poorly designed valve in a nuclear power plant and replace it with a new and better deigned one, the new valve doesn’t try to figure out ways to make you think it is closed when it is really open. But traders will do that.

Lo and Mueller conclude their paper by considering that “the study of economics may be closer to disciplines such as evolutionary biology, ecology, and meteorology”. And indeed, an increasingly popular alternative to borrowing from the tools of physics is to push finance into a biological model. The argument is that in the biological sphere, there is the interaction and feedback that physics lacks. Evolution is the result of this dynamic, of one species changing over time to best another species, just as one trader will change strategies to best another trader. But this model also does not fit. Evolution is not a conscious process. It is a winnowing out of the poorly designed and emergence of the better designed on the basis of the process of natural selection. In contrast, in finance the process is conscious and intelligent.

A better analogy than physics or biology is a military one. The point is that there is a strategy of intelligent reaction to any action, an arms race to leapfrog one another in information gathering and technology, to know what others are doing, and to react in a way that they will not anticipate. This is the point where I could pull out quotes from The Art War about seeing into the mind of the enemy, attacking when your opponent believes you will retreat, and the like. That is not physics.,0,2220225.column

Lou Simpson retiring from Geico

Chicago-based investor once considered successor to Warren Buffett

Melissa Harris


August 22, 2010


Lou Simpson, the Chicago-based investor with such a stellar track record he once was considered the successor to Warren Buffett, is retiring at the end of the year after decades managing Geico's investment portfolio. Geico is owned by Buffett's investment vehicle, Berkshire Hathaway. Simpson, 73, who grew up in Highland Park, is the only person other than Buffett who controls Berkshire investments. "I wish he weren't" retiring, Buffett told me. "Obviously, I would keep him employed till he was 100. I was very surprised when he called me a month ago and said, 'At 74, I'd just as soon turn it over to somebody else.' It was not a happy day at Berkshire. But I'm happy for him." The two have never delineated their stock picks; Geico's investments are described publicly as Berkshire's. So for about 15 years, reporters and Wall Street analysts often assumed Simpson's moves were Buffett's. "People are always attributing to me what he's doing," Buffett said. But here's how to figure it out: "If you see a purchase on a company in the $300- to $400-million range, odds are very good that's Lou's," Buffett said. "I'm going to want to buy at least $1 billion of whatever it is we buy. So Nike, those things are his, while Wells Fargo, Kraft, those will be mine." While Simpson is not a household name, he is among the most well-connected men in Chicago's financial circles. He manages a $4 billion portfolio that posted annual losses only three times from 1980 to 2004, and outperformed the S&P 500 18 of those years. Berkshire has not reported Simpson's performance separately since 2004, but when pressed, Simpson said his stock portfolio has outperformed the S&P 500 in aggregate since then. His monthly reports go to Buffett, 79, and Buffett will assume control of Geico's portfolio when Simpson retires, he said. Buffett and Simpson have similar investing philosophies, although not on life. Both tend to buy and hold stocks. They scour for sturdy but sometimes obscure companies poised for growth. Any other method is considered "a fad." As for whether Simpson runs investment decisions by Buffett, Buffett said never. But their value-investing approach has led to them on at least two occasions to make identical choices. Buffett said both began buying Tesco, a global food retailer, at the same time. And Simpson said both began selling Freddie Mac in 2001 because of concerns the company was overleveraged. "My approach is eclectic," Simpson said. "I try to read all company documents carefully. We try to talk to competitors. We try to find people more knowledgeable about the business than we are. We do not rely on Wall Street-generated research. We do our own research. We try to meet with top management." Simpson, unlike Buffett, avoids the spotlight. Since Berkshire bought Geico in January 1996, Simpson said he has given two on-the-record interviews, this one being his second. "So many people broadcast what they buy or sell and it works against them," Simpson said. "I'm in favor of people not knowing what we're doing until the last possible time." Simpson's priorities, friends say, have changed since he met his second wife, Kimberly Querrey, a chemical engineer, at a restaurant in Chicago. Neither was living here at the time; they were here on business.. She persuaded him to move from San Diego to Chicago, as she was looking for a city that offered her more consulting opportunities. They practiced yoga together until she ruptured her Achilles tendon, and now Simpson does so on his own. They intend to spend most of his retirement in Florida and use their Michigan Avenue condo as a second home. Simpson attended Northwestern University for a short time and, unhappy there, transferred to Ohio Wesleyan and went on to graduate school at Princeton. (Today, he sits on the investment committee of Northwestern's board of trustees.) Simpson had risen to chief executive of California-based Western Asset Management when his friend Leland Getz, the then-vice chairman of executive search firm Russell Reynolds, called on behalf of Geico in 1979. Simpson rebuffed him twice, acquiescing on the third try "only to get him off my back," he said. "Geico, operationally, has made a profit most of the 31 years he has been here," said Geico CEO Tony Nicely. "That has given him great flexibility as to how to invest. He had the comfort of knowing he was not going to have to sell equities in an untimely way. But at the same time, his outstanding performance has caused our overall performance to look unbelievably good." Simpson acknowledges that his more than 30-year association with Buffett and Berkshire has given him entre into circles that might otherwise have been inaccessible. He sits on the boards of two public companies and has been a director of at least nine others. He travels to Allen & Co.'s annual conference for "moguls" in Sun Valley every year. Yet Simpson's life is simple. He supervises only two employees, an assistant and an analyst, working out of a small four-room office on Michigan Avenue. The walls are sparsely decorated with posters from art museum exhibits. He lives within walking distance of his office. His division's daily report covers less than one-quarter of a sheet of paper. "Our dinner conversation, I think it's quite interesting, but some people will say quite strange," Querrey said. "Over the weekend, we actually talked about behavior in corporate America, and the behavior at Hewlett-Packard, and the arrogance of CEOs and why they think they are above enforcement of the board. I have investments in Vietnam. So we often talk about the economy in Vietnam versus the United States." Simpson's compensation is not disclosed, but it is based on his returns over a three-year period. I told Simpson that Buffett often says there are Berkshire stockholders who should be on Forbes' list of the 400 wealthiest Americans but have been overlooked. I asked Simpson whether he is one of them. "No," he said quickly. But with a sly grin, he added, "But I know who some of them are." Melissa Harris, who guesses Simpson will find some relief in no longer having to field opinions on Geico's commercials, can be reached at 312-222-4582 or Twitter@ChiConfidential.

Copyright © 2010, Chicago Tribune

The Future of Housing Finance

We'll never get a rational mortgage system until the government's affordable housing mandates are ended.


Today the Obama administration will begin a discussion on how to overhaul our nationalized housing finance system. Moderated by Treasury Secretary Timothy Geithner and Shaun Donovan, secretary of the Department of Housing and Urban Development (HUD), the "Conference on the Future of Housing Finance" seeks answers to what went wrong in the U.S. housing market. This promises to be the next big domestic policy debate—one that could mold housing finance for a generation or more. But the early signs of where policy makers might be headed are not promising.

A consensus is building around a three-part grand bargain:

• An explicit federal guarantee of a large portion of the mortgage-backed securities created to finance American's home mortgages;

• A tax on these securities to fund low-income housing initiatives; and

• A requirement that issuers of securities meet affordable housing mandates.

This is a dead end for two reasons. First, while supporters of an explicit federal guarantee tell us it will never be called upon, Americans have read this book before and know how it ends.

Former Chief Credit Officer Edward Pinto explains how it all went wrong.

The second is much less well known but equally deadly: the central role in the recent real estate collapse that was played by the federal affordable housing policy created by Congress and implemented since the 1990s by HUD and banking regulators.

In 1991, the Senate Committee on Banking, Housing, and Urban Affairs was advised by community groups such as Acorn that "Lenders will respond to the most conservative standards unless [Fannie Mae and Freddie Mac] are aggressive and convincing in their efforts to expand historically narrow underwriting."

Congress made this advice the law of the land when it passed the inaptly named Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (GSE Act of 1992). This law imposed affordable housing mandates on Fannie Mae and Freddie Mac.

Thus, beginning in 1993, regulators started to abandon the common sense underwriting principles of adequate down payments, good credit, and an ability to handle the mortgage debt. Substituted were liberalized lending standards that led to an unprecedented number of no down payment, minimal down payment and other weak loans, and a housing finance system ill-prepared to absorb the shock of declining prices.

In 1995, HUD announced a National Homeownership Strategy built upon the liberalization of underwriting standards nationally. It entered into a partnership with most of the private mortgage industry, announcing that "Lending institutions, secondary market investors, mortgage insurers, and other members of the partnership [including Countrywide] should work collaboratively to reduce homebuyer downpayment requirements."

The upshot? In 1990, one in 200 home purchase loans (all government insured) had a down payment of less than or equal to 3%. By 2006 an estimated 30% of all home buyers put no money down.

"[T]he financial crisis was triggered by a reckless departure from tried and true, common-sense loan underwriting practices," Sheila Bair, chair of the Federal Deposit Insurance Corporation, noted this June. One needs to look no further than HUD's affordable housing policies for the source of this "reckless departure." If the mortgage finance industry hadn't been forced to abandon traditional underwriting standards on behalf of an affordable housing policy, the mortgage meltdown and taxpayer bailouts would not have occurred.

Compounding HUD's forced abandonment of underwriting standards was a not-unrelated move to increased leverage by financial institutions and securities issuers. They were endeavoring to compete with Fannie and Freddie's minimal capital requirements. The GSEs only needed $900 in capital behind a $200,000 mortgage—many of which had no borrower down payment. Lack of skin in the game promoted systemic risk on both Main Street and Wall Street.

How should we go about repairing this dysfunctional housing finance system?

The goals should be larger down payments, stricter underwriting standards, reliance on the private sector and private capital, and the removal of affordable housing mandates. If there is to be an affordable housing policy, it should not be implemented by hidden subsidies and loose lending standards, but instead made transparent and funded on budget by the government.

Getting there will take time—probably a 15-year rebuild that fosters an orderly phase-out of government guarantees and a transition to a deleveraged, market-based system. This will require both long- and short-term policies.

Long-term we should consider ideas such as: the proposal by Columbia University's Charles Calomiris to increase minimum down payments by 1% per year over 15 years, bringing them back to 20%, where they had been for decades. Peter Wallison of the American Enterprise Institute has suggested that the private sector be encouraged to grow by reducing the GSEs' maximum mortgage amount by a percentage every year until it matches the Federal Housing Administration's (FHA) reduced limit, at which point the GSEs disappear. I have suggested that the FHA be returned to its former role of serving the low-income market over a five-year period, but with a higher minimum down payment so borrowers have more skin in the game.

Finally, the property appraisal process should be re-engineered along the lines suggested by the Collateral Risk Network, an organization representing the nation's leading appraisal experts. The boom was promoted by appraisal practices that relied on one input—the latest prices that were the result of an overheated market. A return to traditional appraisal theory based on price trends, replacement cost and value as a rental is necessary.

To get the housing finance system out of intensive care, short-term policies need to be implemented that promote deleveraging. Perhaps some of the excess supply of foreclosed properties should be sold to buyers who agree to put 40% down and use the properties as rentals. Josh Rosner, managing director of the research firm Graham Fisher, has suggested that homeowners who voluntarily pay down a portion of the principal on their underwater mortgage receive a tax credit also applied to their mortgage principal. In return, they would forgo future tax deductions of their mortgage interest payments.

While the road to housing hell may have been paved by the government, the road back will be built by the private sector.

Mr. Pinto, a consultant to the mortgage finance industry, was executive vice president and chief credit officer at Fannie Mae in the late 1980s.

Subprime 2.0 Is Coming Soon to a Suburb Near You: Edward Pinto

By Edward Pinto - Sep 7, 2010

Bloomberg Opinion

On the second anniversary of the bailouts of Fannie Mae and Freddie Mac, it’s now obvious that weak lending standards, serving the political interest of affordable housing for all, were the main reason for the nation’s mortgage meltdown.

But the government just can’t permit lending to anyone and everyone; it must insist on prudent judgment about who will repay and who will default. Not only will borrowers who lack a down payment, steady income, employment and a good credit history probably get into trouble -- surprise! -- but too much irresponsible lending also creates artificial demand for houses, driving prices into the stratosphere and, as we have just experienced, puts all homeowners at risk.

The same mistake occurred in 1929, when any investor could buy stocks on margin with as little as 10 percent down. Small wonder that after the crash the U.S. government instituted a margin requirement of 50 percent down.

Congress should apply the same principle to housing purchases, increasing the amount a buyer must put down and other safeguards to assure prudent lending. Congress refuses to do this. Why? Giving citizens cheap, easy housing is a great way to win votes, no matter what horrific repercussions ensue.

Who’s Following Whom?

Consider the prevailing narrative that holds a greed-driven private sector responsible for the 2008 financial crisis. A secondary narrative points to a greed-driven Fannie Mae and Freddie Mac abandoning their credit standards in an effort to follow the lead of Wall Street.

If these explanations fail to convince, a third blames a combination of deregulation and insufficient regulation, again driven by greed, as rulemakers were asleep at their posts.

What is missing is the central role played by an affordable housing policy built upon the misguided concept of loosened underwriting -- a policy created by Congress and implemented for 15 years by the Department of Housing and Urban Development and banking regulators.

From 1993 onward, regulators worked with weakened lending policies as mandated by Congress. These policies systematically dismantled a housing-finance system based on the common sense principles of adequate down payments, good credit, and an ability to handle the mortgage debt.

No Money Down

Substituted was a scam of liberalized lending standards that turned out to be no standards at all. In 1990, one in 200 home-purchase loans (all government insured) had a down payment of less than or equal to 3 percent. By 2003, one in seven home buyers had such a low down payment, and by 2006 about one in three put no money down.

These policies led millions of Americans to buy homes with little or no money down, impaired credit and insufficient income. As a result, our economy has been brought down and the taxpayers have had to foot the bill for bailout after bailout.

Congress and U.S. President Barack Obama’s administration refuse to learn the lesson that is painfully aware to American taxpayers, and they have made it clear that they have no intention of fixing broken underwriting.

Let’s start with the latest pieces of evidence. The Dodd- Frank Bill, signed in July 2010 by the president, omitted both an adequate down payment and a good credit history from the list of criteria indicating a lower risk of default as regulators sought to define a qualified residential mortgage.

‘Prudent Underwriting’

This was no oversight. Republican Senator Robert Corker and others proposed an amendment that would have added both a minimum down-payment requirement and consideration of credit history along with the establishment by regulators of a “prudent underwriting” standard. This amendment was defeated.

In early September 2010, Fannie and Freddie’s regulator, the Federal Housing Finance Agency, following requirements set out in 2008 by Congress, finalized affordable housing mandates that are likely to prove more risky than those that led to Fannie and Freddie’s taxpayer bailout. As required by Congress, these new goals almost exclusively relate to very low- and low- income borrowers. Meeting these goals will necessitate a return to dangerous minimal down-payment lending, along with other imprudent lending standards.

Of course, FHFA Director Edward DeMarco notes that Fannie and Freddie aren’t to undertake risky lending to meet these goals. As has already been noted, Congress doesn’t consider low down payments and poor credit as indicative of risky lending. How convenient.

Return to Subprime

The Federal Housing Administration, in its actuarial study released late last year, projected that it will return to an average FICO credit score of 635 by 2013. This signals the FHA’s intention to return to subprime lending. Once again, Dodd-Frank supports this policy change.

The FHA, the Veterans Affairs Department and the Agriculture Department’s grip on the home-purchase market increases month by month. They now guarantee more than half of all home-purchase loans. However, skin in the game isn’t a requirement. For example, the FHA’s average down payment is just 4 percent. Even this meager amount disappears after adjusting for seller concessions and financed insurance premiums.

On Christmas Eve in 2009, the Treasury Department announced new terms to the bailouts of Fannie and Freddie. Starting on Jan. 1, 2013, the terms of the bailout agreement provide for a continuing obligation to provide about $274 billion in capital to Fannie and Freddie. This amount is in addition to the unlimited sums that are available between now and Dec. 31, 2012. As a result, one or both of these entities can now continue indefinitely as zombie institutions under conservatorship.

As a society, we have to go back to at least 20 percent down, with limited exceptions. Credit histories need to be solid. Documentation has to be iron-clad. Lender capital levels need to be raised.

Here’s my proposal to bring Congress’s penchant for imprudent lending to a quick end: All congressional pension assets should be invested in funds backed solely by the high- risk loans mandated by federal housing legislation. I have a feeling that things would change fast.

(Edward Pinto, a mortgage-finance consultant, was executive vice president and chief credit officer at Fannie Mae from 1987 to 1989. The opinions expressed are his own.)

To contact the writer of this column: Edward Pinto at

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