The 19th Hole

There are approximately 8,500 banks in the United States; two fewer as of this past Friday. One in Houston (Franklin Bank) and another in Los Angeles (Security Pacific) were shut down by the federal regulators. A total of 19 so far this year. Writing for the Associated Press on November 8, Marcy Gordon presented the details: “The Federal Deposit Insurance Corp. was appointed receiver of Franklin Bank, which had $5.1 billion in assets and $3.7 billion in deposits as of Sept. 30, and of Security Pacific Bank, with $561.1 million in assets and $450.1 million in deposits as of Oct. 17.”

A reflection of our times, but the real story in all of this resides with co-founder and chairman of parent Franklin Bank Corp., Lewis Ranieri, a pioneer – a legend actually – in the hallowed “vaults” of modern banking history. He must have been deeply saddened as he watched his 46 branches being transferred to the Prosperity Bank of El Campo, Texas. Gordon noted when the bank’s board of directors first spotted an issue: “Last spring, the audit committee of the company's board found in an investigation certain weaknesses in accounting, disclosure and other issues relating to residential real estate loans.” Routine stuff, really, except for that “special something” that defined Ranieri’s role in banking history.

You see, about two decades ago, Mr. Ranieri unwittingly lit the fuse – a really slow fuse – that would eventually explode in the subprime derivatives bomb. Ranieri is credited as the inventor of the mortgage-backed security – a commercially tradable piece of paper which reflects the aggregate value of a bundle of mortgages (i.e., the value of mortgages themselves supported the tradable paper). This allowed banks to “sell” bundles of mortgages to funds, investors, other banks, etc. – who rated the risk and profited from the income generated by homeowners’ making interest payments – at a lower value than the face of the aggregated mortgages (hence buyers could make money on the difference). This gave the selling bank a slightly lower profit on the originating loans, but it freed up capital to make lots more loans. They literally “made it up in volume.”

This did create “distance” between the homeowner and ultimate buyer of the mortgage – the originating bank was out of the loop now – but it allowed a larger pool of money to be available for people to buy homes. This is all a bit complex – and you may have to read this more than once – but yes, a mortgage-backed security is a pretty classic “derivative” – a tradable financial contract, or financial instrument, whose value is derived from value of an underlying asset or a pool of like-kind assets bundled together to create an averaging effect. The underlying asset(s) on which derivatives are based can be elements such as commodities, equities (stocks), residential mortgages, commercial real estate loans, bonds, interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI), according to Wikipedia.

Yeah, residential mortgages. Where the derivative is based on some aggregation of debt, it can also be referred to as a “synthetic collateralized debt obligation” – whew, except “synthetic” is at least kind of a warning sign to look closer! Picture an aggregation of thousands of mortgages, separated into relative risk pools, where you can buy a “security” (a piece of paper like a stock or a bond) whose price is based on the total value of those pools (corrected for risk).

The real damage came years after Ranieri first introduced his mortgage-backed security… as this aggregation of mortgages was used in the post-2004 era primarily to bury and “rate” mortgage risk into manageable pools, which would enable the system – bankers believed – to tolerate lower lending standards and generate higher yields associated with higher risk loans. In short, when less-than-prime customers could borrow money where they would have been clearly denied a home loan in the past, this “mortgage-backed security” was supposed to manage the risk by pooling the loans to minimize the impact of individual defaults. From 2004 until the market dropped, home loans were now flowing like a raging river. Hmmmm?

With about $7.2 trillion in these subprime mortgage derivatives “out there” (many in default) and the bulk of the 23% of U.S. homes where mortgages exceed the value of the home falling into that subprime category, let’s just say they were wrong. Really, really wrong. There weren’t just a “few defaults” as the system had predicted. And with half of America’s banks likely to tap into the temporary FDIC increase in deposit coverage ($250,000 per accounts) and $40 billion of FDIC estimated losses from bank failures expected by 2013, isn’t ironic that the inventor of mortgage-backed securities was brought down by his own creation?

I’m Peter Dekom, and I learn something new every day.