Banks, like public, bet the store on real estate bubble

November 23, 2007|By Kevin Hall | Kevin Hall,McClatchy-Tribune

WASHINGTON -- Big-name investment banks are taking a financial beating this year, leaving many Americans to ask: Just how did all these Wall Street bankers in their $5,000 John Lobb shoes manage to step in you-know-what?

The answer is simple: They made the same mistakes as the rest of us, just with more zeros attached to them and bigger consequences for the U.S. economy, if not for their own $625 John Lobb wallets.

Those mistakes are why the heads of Merrill Lynch & Co. and Citigroup Inc. have been ousted in recent weeks, why household names such as Bank of America Corp. and Wachovia Corp. are announcing billion-dollar losses and why more trouble is brewing.

Individual investors frequently lose money by chasing past returns, deciding on future investments by looking at past performance instead of future market conditions.

Investment banks did just that amid the booming housing market. They mirrored each other's moves as they raced into ever-shakier lending. Some estimates suggest that collectively they'll lose more than $400 billion.

"They are basically a herd of sheep. They all go into it together," said A. Gary Shilling, a financial consultant and television commentator who warned in 2005 and 2006 of troubles to come. In the 1980s, banks followed each other into Latin American debt. Later, he said, they all got burned together by losses in manufactured housing.

In hindsight, the risks from an overheated housing market seem obvious. But in a now-famous July interview with London's Financial Times, then-Citigroup Chief Executive Officer Charles O. Prince III appeared to confirm the sheep metaphor when he shrugged off the imminent danger.

"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing," he said.

Not anymore. Prince resigned Nov. 4 with a golden parachute worth an estimated $43 million. His resignation came days after Merrill Lynch Chief Executive Officer E. Stanley O'Neal was forced out, taking with him compensation worth $160 million. Neither man had "dirt under the fingernails" experience in the complex mortgage-finance market.

With the notable exceptions of Goldman Sachs & Co. and Lehman Bros., most Wall Street investment banks made the same fundamental miscalculation made by many average Americans.

That mistake was assuming that home prices might flatten but wouldn't fall.

Individuals believed they couldn't go wrong. Investment banks concluded the same, relying on complicated financial models dating back to the 1930s that showed that home prices defy the laws of gravity.

Investment banks didn't make the loans. They bought them from loan originators and packaged them together - called securitization - into special mortgage bonds to be sold to investors.

The bonds were often mixed into another offering called a collateralized debt obligation (CDO), which blended assets and debt into a financial instrument that offered potentially huge returns to those with the stomach for risk.

This bundling helped many Americans get into their first homes. But in late 2005, according to the Federal Reserve, things went awry.

Loan originators, many of them non-bank lenders such as now-bankrupt New Century Financial Corp., lent money without verifying borrowers' incomes. Borrowers inflated what they really earned. And Wall Street asked few questions as it gobbled up loans for bundling.

It was all based on a somewhat irrational premise.

"Subprime credits and risky credits had been good for a long time. The number of defaults from real estate loans and all that lending had been exceedingly small, and there was this notion by some that anything that is collateralized by real estate is safe because nominal real estate prices never go down," said Jeremy Siegel, the author of The Future for Investors and a finance professor at the University of Pennsylvania's Wharton business school.

Furthermore, economists trumpeted that business cycles were now longer and more stable, while recessions had grown less frequent and shorter. The perception of risk fell, and so did the risk that premium banks calculated into their lending rates.

"There wasn't anything you could point to say, `This is a really a bad bet,' like Internet stocks or other equity crazes that occur every so often," Siegel said.

Cheap money added to the missteps.

After the Sept. 11 terror attacks, the Federal Reserve lowered its benchmark short-term interest rate to 1 percent in June 2003, held it there until June 2004 and didn't bump it back above 3 percent until June 2005. Interest on deposits virtually vanished, and yields on long-term bonds and Treasury bills fell. Investors and investment banks were hungry for anything that seemed to promise higher returns.

The seemingly safe bonds consisting of bundled U.S. mortgages were just the fit.

Historically, the quasi-government company Freddie Mac has bundled mortgages for sale to conservative investors. But that gave way to an explosion of investment-bank bundling of mortgages, especially the bundling of riskier subprime loans.

In 2001, so-called private-label mortgage bonds totaled $95 billion, but by 2005 they surpassed Freddie Mac bundling and in 2006 reached $450 billion. Subprime loans backed about 38 percent of private-label mortgage bonds.

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