As deregulation progressed, the effects of the monopolies created to overcome the Great Depression and Axis nations finally faded. The first sprouts of a level playing field in finance began to emerge within U.S. trading markets and among our trading partners. Without new risk averse transaction structures to support new entrants, however, the advantages of deposit insurance prevented the sprouts from growing enough to support U.S. capital market needs.

In all trade, riskless arbitrage is the process that moves markets from monopoly to competition. If a local monopolist raises prices or rates, its profits are restricted when outsiders find ways to use lower prices elsewhere to bring goods (or money) into the monopolist’s market, risk free, to sell at a price lower than what the monopolist charges. The key to creating a true level playing field in finance, therefore, is to generate true riskless arbitrages that are indubitably safe and allow the new sources of money to grow and compete with former monopolists.

Many people are shocked when we say that the hangover of the Great Depression lasted nearly half a century, but this is the reality in terms of credit creation and private-sector growth. “Contrary to conventional wisdom, FDR’s New Deal did not rescue the economy from The Great Depression,” notes author and columnist Sol Sanders. “That took the unprecedented World War II mobilization which revamped the American economy’s entire nature, producing the great postwar prosperity” (Sanders 2014).

Such is the power of the mythology of the World War II and Cold War eras created by the media that few of the citizens of the victor nations realized that the government expenditures needed to fuel the conflicts (and rebuilding thereafter) are what drove the recovery of jobs and economic growth for three decades after V-E Day. War itself wastes a great deal of manpower and materials, but the vast government outlays needed to rebuild postwar Europe and Japan, combined with the military and technological buildup involved with the Cold War, provided ample liquidity and economic stimulus to the United States and its allies. Another decade of work remained, however, before financial market alchemists created arbitrage transactions that were sufficiently risk free to reintroduce financial intermediation structures that existed prior to the 1929 crash.

In 1983, a riskless arbitrage innovation emerged that changed everything: the stand-alone collateralized mortgage obligation, or CMO. The stand-alone CMO is the only financial innovation of the past several centuries that, when properly implemented, generates profit merely by altering the intermediation process. We discuss later how these instruments came to be debased in the period from 1998 to 2008. For now we focus on the process and forces that led to and were unleashed by its creation.

The CMO is an advanced form of mortgage-backed security built on the new foundations for secured borrowing discussed in the previous chapters. The process pairs investors that have similar prepayment preferences to structurally segregated mortgage cash flows that remarkably improve the likelihood of attaining each investor’s preference. It allows intermediaries to “buy” mortgages at low prices (reflecting high prepayment risk) and to “sell” securities with lower prepayment risk (at higher prices)—a “perfect” riskless arbitrage.

CMOs used cash flows from mortgage-backed securities guaranteed by the federal housing finance agencies Ginnie Mae, Freddie Mac, and Fannie Mae. These agency securities merely pass-through payments on underlying mortgages to the owner of the security as mortgage payments are due or prepaid, even when the underlying mortgages default. Thus, they give no “prepayment” protection.

CMOs then use the guaranteed cash flows to pay bonds issued by an intermediary owner in a very strictly prescribed order of payment. The intermediary company buys the mortgage-backed securities and funds that purchase by selling bonds with maturities based on the specified payment order to investors that are paid in order, with mortgage proceeds going first to some investors and later to others.

Although eventual payment of all interest and principal payments on the mortgages is guaranteed, for true stand-alone CMOs, the timing of payment was not guaranteed.

Underlying mortgages and normal pass-through securities prepay more rapidly (1) when defaults rise, and (2) when low mortgage interest rates cause performing mortgages to be refinanced. Conversely, when rapid prepayment is expected and then gets delayed (e.g., because rising interest rates slows the refinancing of performing mortgages), the mortgages and pass-through securities will be paid more slowly. Since CMOs pay investors in a preset order, the security creates a sharing of prepayment risk by allowing investors to choose bonds based on order of payment. Actual payment timing as the mortgages are paid, however, will depend on market factors.

In finance, bond investors love prepayments when interest rates rise and hate them when interest rates fall, in the latter case because the reinvestment rate is lower. A bond that performs well by those tests is said to have positive convexity. Because mortgages generally prepay more rapidly when rates fall and more slowly when rates rise, mortgage investments are said to have negative convexity. The Federal Home Loan Mortgage Corporation, or Freddie Mac, takes credit for introducing the first CMO in early 1983. It created a highly efficient security structure for distributing mortgage cash flows from homeowners to investors. In fact, the structure was overly efficient, because Freddie Mac actually guaranteed the timing of repayment on the CMOs, a guarantee that over time could only be supported by a government agency. Freddie Mac’s CMO structure, therefore, created a monopoly to benefit only the largest banks and federal housing finance agencies because no private issuer could finance the guarantee of the timing of repayment on similar terms.

The first stand-alone CMOs were designed to reduce the negative convexity risk of mortgage investment for investors but not to eliminate the risk. The intermediary that creates a CMO can therefore profit by creating securities that generate more cash than is needed to purchase the underlying pass-through securities. We will explain later how that advantage of CMOs came to be monopolized by the large banks and housing GSEs after 1998 and was manipulated to the detriment of investors. This was a major cause of the 2007–2009 crisis and the Great Recession.

The changes in laws that made the CMO (and its various permutations) possible include the Uniform Commercial Code, the U.S. Bankruptcy Code, and the Uniform Fraudulent Transfer Act—each of which responded to court decisions and regulations imposed from the 1920s onward. Over the decades since its 1983 creation, the CMO has changed everything in finance—both for good, and, at times, for bad.

The first stand-alone CMO was issued in June 1983. An affiliate of Pulte Home Corporation broke the Freddie Mac monopoly by creating CMOs that only paid as their underlying mortgages paid or prepaid. That allowed the Pulte CMO to be a true riskless arbitrage and go viral. Anyone who understood the process could enjoy arbitrage profits, risk free, by buying guaranteed pass-through securities and selling CMOs. By 1987, more than $60 billion of stand-alone CMOs had been issued by a variety of institutions and entrepreneurs.

Investment bankers, homebuilders, thrifts, mortgage bankers, insurance companies, and real estate investment trusts (REITs) issued these CMOs for a variety of reasons. The advent of the stand-alone CMO revolutionized housing finance and in particular expanded the possible investment pool for housing beyond the monopoly of bank, thrift, and agency balance sheets. CMOs raised new funds that allowed builders to build more homes that were collateralized by the mortgage payments made on homes that had previously been sold.

In a pattern that is all too familiar, the CMO’s success quickly drew pretenders. Its proper use as a risk-free arbitrage soon lost its magic as the CMO concept spread to credit risk trades. The strategy adopted by one firm, U.S. Home, to expand into manufactured housing in rural areas was less than astute. Manufactured housing in the United States was an outgrowth of World War II, when millions of semi-permanent dwellings were required to house troops and refugees.

U.S. Home acquired Brigadier Industries, one of the nation’s largest producers of manufactured (that is, mobile) homes. The acquisition was intended to allow U.S. Home to operate more efficiently and better leverage the new financing technique. But the firm did not anticipate the collapse of the oil sector and the resulting decrease in the demand for such homes. The oil patch bust left U.S. Home with a chronic overcapacity for many years and nearly bankrupted the firm. But the problems being experienced by U.S. Home in the mid-1980s in the so-called oil patch states of Texas, Oklahoma, and Louisiana were just one part of a broader debacle in the housing sector.

The stand-alone CMO that Pulte invented was a very positive development, which helped millions of Americans achieve their dream of homeownership. As the operating problems experienced by U.S. Homes proved, however, every financial innovation can be destroyed by misuse. Thus, finance will always be a business with positive and negative aspects.

The virtues of stand-alone CMOs were soon tarnished by abuses and acts of fraud—acts not unlike those committed a century before in the decades leading up to the Great Crash. These bad acts hid the merits of very useful vehicles under a mountain of problems. A free society disperses and reduces the damage of fraud by equally permitting success and failure. History teaches that precluding freedom in order to end fraud merely centralizes corruption and increases the damage caused.

At about the same time that U.S. Home was jumping into the deep end of the pool with respect to manufactured housing, a series of failed experiments in deregulation began generating a huge off-balance sheet financial bubble, primarily in the Southwest region of the United States—the very area that U.S. Home saw as being ripe for expansion.

The financial bubble that burst in 1987 to become the S&L Crisis was the first serious financial crisis since the real estate bust of the late 1920s and the subsequent Great Depression of the 1930s. This calamity may not seem as serious as the subprime bust that occurred 20 years later, but the S&L crisis nearly bankrupted the United States in 1988.

After 1992, as effects of the S&L crisis receded, virtues of the stand-alone CMO resurfaced. The structure was expanded to financial assets other than home mortgages. It was used to revolutionize the automotive finance industry just in time to save GM after it suffered enormous losses in 1992. Another bout with mortgage abuse, however, also emerged from the obscurity of a few private placements to become a dominant part of the government sponsored mortgage market: the companion class CMO. To understand this evil twin pretender to the CMO, one must start by understanding its companion, the planned amortization class (PAC) CMO.

The reduced loan repayment uncertainty, or negative convexity, that makes stand-alone CMOs so attractive to investors led very large and influential bond investors to demand that underwriters create securities with ever-greater certainty as to the timing of cash flows. Achieving that desired payment preference, however, meant someone else would have to accept a CMO class with even higher than normal prepayment/deferral risk. Investment bankers therefore invented a PAC/companion as a pairing structure where the preferred PAC investors got a greater share of payments when mortgage prepayments slowed and a smaller share when loan repayments accelerated.

This created a need for investors willing to buy the toxic waste companion class so favored investors could get the more predictable cash flows with PAC bonds. Companion class bondholders would receive much faster prepayment when interest rates fell and much slower prepayment when rates rose, meaning that the effective maturity, or duration, of the security—and therefore its market value—could change greatly.

These companion securities were called sucker bonds for good reason. Holders of the evil twin bonds, which were generated to give preference to buyers of PAC bonds, got stuck with acceleratable negative convexity, a concept many investors and sponsors never understood.

With stable rates, companion class investors would be paid in one to three years, so special funds were created to buy short-term agency securities, financed by selling commercial paper to money market funds and other unsuspecting groups. If rates rose, of course, those short-term funds might see duration explode and only be paid in 20–25 years. Nobody can safely hedge that investment risk.

One rating agency, Standard & Poor’s, tried to warn investors by forcing issuers of companion class CMOs to label them with an r. That was soon referred to as the scarlet letter of risk in mortgage finance.

Unfortunately, by the time the PAC/companion structure became common, federal income tax law had changed to confer a near-monopoly on CMO issuance that favored the federal housing agencies (GSEs). The real estate mortgage investment conduit (REMIC) tax structure became the exclusive legal format available for multiple class CMO securities. By the time S&P insisted on its r designation for companion class CMOs, roughly 95 percent of the sucker bonds were issued in CMOs created by the GSEs. Being GSEs, they did not need or obtain ratings for the securities—but this did not change the riskiness of the securities they issued.

S&P’s effort to warn investors, therefore, was futile. A security suitable for perhaps 0.5 percent of all mortgage market investors comprised as much as 30 percent of all CMO issuance as 1993 was coming to an end. Until then, Fed chairman Alan Greenspan suppressed the Fed funds rate after the recession of 1990/1991 emerged, but eventually rates had to rise.

At the end of 1993, the Fed began considering a preemptive increase in interest rates to discipline what it perceived as excessive speculation. The Fed’s belated move to impose interest rate discipline would nearly destroy several money market funds because of the embedded timing risk of sucker bonds.

As short-term interest rates rose, several funds managed by Askin Capital Management that were created to hold companion class CMOs became unable to repay repo loans that Kidder, Peabody had made to the funds so that they could buy portfolios of companion class bonds. These loans were made because Kidder needed to sell the sucker bonds in order to dominate PAC issuance and corner a large part of the GSE CMO market.

The resulting bankruptcies ended Kidder, Peabody’s role as an underwriter. Reverberations of the turmoil caused several money market funds to break the buck, an event that triggered a series of blunders that are key to dissection of the crises that followed in 1998, 2000, 2001, 2003, 2005, and 2007–9.

Banc One of Ohio was also caught in the duration explosion caused by the Fed’s interest rate increase. In that era, Banc One had piled into interest rate swaps with Wall Street, basically betting that interest rates would stay low and stable. Before merging with First Chicago in 1998 (to become Bank One), Banc One reportedly had a negative carrying value of its derivatives portfolio that was roughly equal to the entire capital of the holding company.

Almost nobody inside or outside the regulatory community understood the term, much less the substance, of acceleratable negative convexity during this period in 1992–1994. As a result, the SEC thrashed around in a fog seeking ways to protect money market fund investors from a problem that the SEC had not defined. The agency enacted new money market fund rules in 1998 that, along with the absurd exclusivity of REMICs, were key contributors to every financial crisis since 1994.

Understood and offered properly, the acceleratable negative convexity of companion class CMOs is not inherently bad. It’s complex. In the hands of investors or bank managers that do not understand the securities or abuse them to secretly speculate with other peoples’ money, however, the securities are destructive toxic waste that allow investors to be duped by false promises of higher returns.

The beneficial economic attributes of stand-alone CMOs and the financing capacity that they represented generated history’s first self-correcting virtuous economy in 1997. While many observers credit the policies of the Clinton administration for the relative prosperity experienced in the mid-1990s, the fact that nonbank financial companies could use vehicles such as stand-alone CMOs (and variations of this model) to raise capital played a big part in the 1990s’ expansion of jobs and economic activity related to the residential housing and real estate sectors, and also a strong manufacturing recovery.

Starting in 1998, mistakes made by policy makers in response to the Kidder, Peabody collapse, which was caused by the 1994 companion class crisis, resulted in market changes that altered the use of these instruments. CMOs and their more exotic variants and derivatives became weapons of mass destruction in the hands of some of Wall Street’s largest financial institutions. The basic model of the CMO was used by the large government-backed banks and GSEs (government-sponsored enterprises) to create off-balance sheet financial monopolies. The banks first gained control of the conforming residential mortgage market by capturing the inflow of mortgages to GSEs (Fannie Mae and Freddie Mac), then underwrote and delivered CMOs that the GSEs created as off-balance sheet debt (despite fully guaranteeing payment-a ridiculous result).

This unreported monopoly ballooned to enormity as international trade imbalances flooded the market and made it impossible to contain the growth of too-big-to-fail large U.S. banking firms and GSEs. They issued and hid mountains of off-balance sheet debt via CMOs and derivative permutations like collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs). All of it was hidden from investors, rating agencies, and the capital standards of regulators. All told, the GSEs and largest U.S. banks created $30 trillion of hidden leverage (shadow banking) to seize control of the rest of the financial market and manipulate prices for all types of securities.

A decade of continuous blunders (from 1998 through 2008) inflated the bubble before the inevitable collapse that arises with every financial market monopoly. That bubble caused the financial Armageddon of 2007–2009.

When the two mortgage GSEs were forced into conservatorship early in September 2008, it opened a capital sinkhole that swallowed $1.6 trillion of U.S. loans, leading to the failure of Lehman Brothers a week later, American International Group (AIG) failed three days after that, and a near total failure of the entire system occurred by late October of 2008, as credit spreads widened to twice the level observed after the 1929 Crash.

This cascade of failures expanded a U.S. financial sinkhole to consume all $30 trillion of the secret excess U.S. leverage that had been created by the large bank monopoly. It exposed an even greater hole ($37 trillion) of even more obvious off-balance sheet manipulation and fraud elsewhere around the world. That’s when the reins of economic power shifted away from large banks to a new generation of public political and monetary leaders. They built a bridge of government liquidity and, we hope, the cooperation needed to sustain that bridge until the United States and its allies can once more create a private financial system that will sustain stable growth. This is what is meant by the phrase nationalization cum monetization.

The stand-alone CMO is the essential instrument for sustained financial stability, but as the subprime debacle illustrates, abuse of the structure via deliberate acts of securities fraud must be contained. The CMO was invented to access a unique financial market opportunity that emerged in 1983, just as Fed Chairman Paul Volcker’s cure for the Great Inflation of the 1970s was succeeding. The Fed’s success allowed it to reduce short-term rates at a time when long-term rates remained unusually high. That created a huge profit opportunity for entrepreneurs that understood how to generate riskless arbitrages that spanned the difference between long- and short-term interest rates—what we call generically the rate spread.

What is unique about the stand-alone CMO is that it’s the first (and only) financial instrument that actually adds value merely by changing the form of the underlying financial assets. The capacity for that transformational increase in value exists when credit spreads widen (the symptom of a financial crisis) and disappears when spreads narrow (consistent with a return to equilibrium).

That counter-cyclicality, in turn, gives stand-alone CMOs the capacity to prevent financial crises by drawing credit spreads toward equilibrium. As spreads widen, stand-alone CMOs generate risk-free profits that attract more and more transactions—a direct parallel to Bagehot’s dictum about using high interest rates to attract capital back into markets in the 1800s. The transactions, in turn, generate countercyclical demand for assets—mainly mortgage loans—which reduces credit spreads just as widening tendencies (created by the procyclical demand associated with a panic) threaten to generate a crisis.

As more of the transactions are done, spreads narrow and profits from originating stand-alone CMOs shrink and eventually disappear. As equilibrium is regained, the transactions no longer generate risk-free profit. Therefore, their use automatically shrinks because profits are restricted to circumstances that are risk free. That makes stand-alone CMO transactions financial shock absorbers that, properly used, help to assure sustained financial stability. They solve the last major problem in macroeconomics.

On a level playing field of finance free of monopoly behavior by large banks and government-sponsored entities, this process can be monitored by a combination of:

• Total transparency (exemplified by the Fed’s recent policy to telegraph and report everything it does and intends to do),
• Full reporting of daily bond market trades,
• Rules mandating that all financial transactions that generate any form of risk be required to provide full disclosure of all involved assets and liabilities.

That’s the promise of the future, however. First, let’s review how the United States has progressed with each of these requirements, beginning with circumstances that led to the 1969 appointment of the level playing field commission. All history of mankind’s folly is a sad dialog. We will seek to add humor when possible. It is the ability of humans to laugh at the irony of their mistakes that makes any recital of our history palatable.

ECONOMIC EXPERIMENTS: FROM VIETNAM TO THE S&L CRISIS

In late 1967, President Johnson was contemplating a huge military build-up, hoping that an increased effort would end the war in Vietnam before the 1968 election. He asked Congress to approve a tax surcharge but did not reveal how much would be spent on the build-up. According to econometric models used at that time, a surcharge was necessary only if the administration was lying (and not just a little bit) about what it intended to spend.

Several runs of one model were offered to the U.S. Treasury Department, using reported budget data and assumptions about undisclosed expenditures. It soon became clear that the administration’s intent was to hide an enormous level of spending for a war that was already tearing apart the fabric of American politics. The Johnson administration was lying about a huge expansion of the war. They were repeating an economic mistake dating to at least 1694, when the English parliament formed the Bank of England to hide funding of their king’s desire for war with France.

The effort led to protests and backfired. President Johnson announced his retirement in 1968, after his defense secretary, Robert McNamara, left office because he opposed Johnson’s build-up. McNamara went on to be president of the World Bank. The loss of life in Vietnam doubled before the war finally ended, and the impact of our many errors continues to affect that region even today. The 1967–1968 budget deceptions also continued and helped generate the Great Inflation of the 1970s.

After he took office, President Nixon appointed the level playing field commission to consider how the United States could reduce constraints on growth created by the silo-monopolies of finance that resulted from Depression-era controls on banking and financial markets known. Under the commission’s December 1971 report, the first obvious candidate for reform was the government’s financial hammer—the Fed’s Regulation Q, which placed ceilings on deposit interest rates.

Because of Regulation Q, it was irrational for any bank to expand lending, which the nation needed for growth of capital. Regulation Q let the government cut off market access to liquidity by the simple expedient of reducing deposit rates below the level a bank needed to attract and retain necessary funding. The very notion of Regulation Q was inconsistent with a free market, but as we have discussed, there was nothing free market about the post-World War II regulatory environment. Banks were heavily regulated appendages of the federal government. Regulation Q was the essential string that tied the Depression-era package of financial reform together. Just as the prohibition on the ability of the Fed to pay interest on reserves stymied its lender role from 1913 to 2008, retaining Regulation Q made no sense if faster growth in the U.S. economy was desired.

Unfortunately, the Depression-era financial model revolved around the concept of prohibiting interest rate competition. The ability to control competition when raising deposits allowed regulators to prohibit credit expansion and block moral hazard speculation at will, but it also relegated the United States to substandard economic growth. Financial deregulation forced the United States to relearn a lesson in finance that seems impossible for many to understand. It’s a lesson that FDR learned between the presidential campaign of 1932 and the harsh reality of March 1933, when most of the banks in the United States were closed. The nature of finance ensures that there is no space, no compromise, between total control and a free financial market. A free society accepts the existence of fraud, but seeks to lessen its impact by encouraging disclosure and remediation.

Unless there is total control, money is entirely fungible. Like water, money slips through any crack in any rule that is inconsistent with a free market. Absent total control, therefore, there must be a free and level playing field where only fraud is regulated to preserve a peaceful society. To ensure fairness, the process of market participation can be regulated, but a participant’s access cannot. In the absence of a level playing field, there is no free market—only the sort of monopoly behavior that characterized the Gilded Age up to the Great Crash of 1929 and also the housing boom of the 2000s that led to the subprime crisis.

Using controls such as Regulation Q to prevent a total collapse, Depression-era laws created separate banking silos in which each type of financial institution had some form of monopoly control that allowed it to profit, but only if it did what government wanted. That concept of government monopoly cannot support any market society’s capital needs and, in the 1960s, a lack of economic growth eventually drove the changes in policy that followed.

Thrift institutions that restricted themselves to making residential home loans were given a Regulation Q and tax advantage over commercial banks so that they could pay more interest on the savings accounts that supported their investments in 30-year mortgages. Since savings could be withdrawn with 30 days’ notice or less, the thrift silo relied on the government to keep a positive spread between short- and long-term interest rates. When that positive yield spread disappeared with the great inflation of the late 1970s, the 1930s thrift model died.

Until the 1970s banks had the exclusive power to provide checking accounts. By law, thrifts and other financial firms could only pay depositors directly, thereby precluding third-party payment accounts. In addition, only banks were effectively allowed to make commercial loans, a business many banks had to relearn under rules of the Uniform Commercial Code put in place after 1951. Regulation Q let the federal government stamp out any hint of loan speculation. It could stop speculation in mortgages, for example, by lowering the Regulation Q margin between banks and thrifts, thereby forcing thrifts to stop lending. As a consequence, homebuilding rose and fell like a yo-yo under Regulation Q (see Figure 9.1 in Chapter 9) based on the whims of the federal government rather than market demand.

As fear generated by the Depression began to fade, lawyers and judges began to forget the reasons for all the anticompetitive rules dividing finance among separately regulated groups. In the mid-1970s, for example, a thrift firm in the Midwest decided to cross the line and compete with banks by offering customers accounts from which funds could be withdrawn by drafts payable to third parties.

The thrift consulted a lawyer who found no prohibition on offering the accounts. The UCC defines a check as a draft drawn on a bank and the lawyer’s client wasn’t a bank. How, therefore, could the thrift be offering a checking account?

The thrift jumped out of its silo and invaded bank turf. Courts eventually agreed that the offer was illegal because withdrawals at thrifts could not be paid to the third parties, only to the depositor. By then, however, federal law had changed to specifically allow the same thing for thrifts all around the country.

In the first stab at deregulation, banks were allowed an exemption from Regulation Q for short-term deposits of more than $100,000. The change was designed to permit large commercial banks a level playing field with issuers of commercial paper, thereby allowing them to gain access to more stable funding sources. Some bank clients were selling commercial paper to the public at rates higher than that allowed by Regulation Q, thus avoiding the bank monopoly on commercial loans to businesses.

As soon as deposits of more than $100,000 were freed from rate restraints, the free market began to operate. Families and brokers began aggregating deposits to get to the $100,000 level, creating the precursors of money market funds to take advantage of the higher rates offered on deregulated deposits. By 1980, Regulation Q had been abolished entirely.

The desire for greater economic growth began in the 1960s as Americans started to borrow from banks in order to invest greater and greater sums in the stock market. Regulation Q precluded banks from attracting consumer deposits, so depositors turned to purchasing stocks. The average daily trading volume on the New York Stock Exchange rose by more than 300 percent during the 1960s, while other markets likewise saw large increases in trading volume. Hurd Baruch, special counsel to the SEC during this period, described the market growth of the 1960s as a frenzied speculative bubble.

A combination of mounting technical problems and enormous growth in trading volume resulted in a near collapse of U.S. equity markets. Stocks lost a third of their value between May 1969 and May 1970. Operational and financial constraints caused the largest number of failures of securities firms since the 1930s. Over 160 members of the New York Stock Exchange failed during this period, and an even larger number of regional brokerages failed. So serious was the damage to public confidence in the markets during that period that Congress eventually passed the Securities Industry Protection Act, modeled after the Federal Deposit Insurance Act.

By the mid-1970s new forms of financial market speculation had been unleashed and were generating mini-panics. One of the most notable was the crisis involving real estate investment trusts, or REITs. In December 1973 a developer in Palm Beach, Florida, named Walter Kassuba, filed for bankruptcy and defaulted on numerous loans that had been made by REITs. The failure started a cascade of defaults that eventually caused many REITs to fail.

These failures, in turn, caused significant losses to commercial banks that had (1) made loans to REITs to fund the sponsoring banks’ expanding commercial lending operations, (2) sold excess commercial real estate loans to REITs they sponsored, and (3) advised the same REITs on how to manage their portfolios. Almost nobody stopped to question whether this multifaceted involvement of the banks might create conflicts of interest that would allow rescission of any transaction that ended badly for REIT investors.

The assets held by REITs fell from almost $500 billion in 1974 to less than $25 billion by 1978. Large New York banks, such as Chase Manhattan and Bankers Trust, suffered serious losses because of defaults on commercial loans made by and to REITs. Throughout the nation, banks that had sponsored REITs found it necessary to repurchase many loans that they thought they had sold. Their sales came home as banks’ conflicts of interest were exposed in court.

Two OPEC oil crunches, an expansion of banking and investment activity, and the accommodative monetary policies supporting the guns-and-butter policies of the Johnson and Nixon administrations all contributed to the Great Inflation of the 1970s. The sharp increase in wage and price inflation caused the Fed to lose credibility until 1979, when Paul Volcker stepped in and took the painful steps needed to control inflation—and, most importantly, inflation expectations.

Without the protection of Regulation Q to control their cost of money, and as a necessary consequence of the Fed’s actions to stem inflation, most traditional U.S. thrift institutions were rendered hopelessly insolvent by 1982.

If U.S. homebuilders that relied on mortgages originated by thrifts wished to survive, they had to figure out how to sell homes as mortgage interest rates ran as high as 17 percent per annum. Even with the steep inflation during and after the American Civil War, rates did not get that high.

For traditional thrifts, the problem extended far beyond the destruction of new lending business. By virtue of the incentives provided under federal law, almost all of the assets of thrift institutions were long-term fixed-rate home mortgages. That business model survived the Great Depression by letting thrifts work with customers to prevent foreclosures while banks (that only made short-term mortgages) were forced to foreclose rather than negotiate. When a borrower defaulted, the thrifts simply added small, deferred sums to the mortgage until the borrower got a job.

As a result of the thrifts’ asset concentration in long-term mortgages, however, when interest rates on short-term deposits zoomed to 12 percent or more, the thrifts were stuck with long-term assets paying perhaps half the cost of deposits that were funding their mortgage loans. Readers who have seen the 1946 Frank Capra movie It’s a Wonderful Life will recall James Stewart explaining to terrified customers that their savings financed the home mortgage loans of their neighbors.

The inflation of the late 1970s destroyed the 1930s thrift model. It left the firms without a survival plan. Reports of the time divided the U.S. thrift industry into 6-, 12-, 18-, and 24-month firms—with the designation signifying the amount of time that the thrift would survive. That number was calculated by dividing the firms’ net worth by the monthly loss on their negative margin between asset earnings (low fixed-rate mortgage interest) and liability costs (rising deposit rates).

By 1982 there were no traditional thrifts with expected lifespans of more than 24 months: within that time, they would all become insolvent and be thrown into receivership. In 1982, Congress and the Reagan administration decided the next step in deregulation should be to let these zombie thrifts invest their way out of trouble by allowing them to make new commercial loans (thereby competing with the former commercial bank monopoly) at the prevailing high rates.

Mr. Reagan’s conservative and very intelligent FDIC chair, Bill Seidman, was asked by reporters to comment after President Reagan signed the bill in the White House rose garden and proclaimed, “We have finally freed the free enterprise system.” Mr. Seidman quietly said, “I don’t see any of those guys asking for freedom from the government’s guarantee of their liabilities.”

After the dust cleared and his service to the nation as head of the RTC (the agency that cleared up the rubble of that 1982 error) was ending, the last question someone asked Seidman after a retirement speech at the Economic Club of Detroit was, “How much is this mess going to cost?”

Obviously irritated at having answered that question about 5,000 times, he told the audience, “I have no idea how much this will cost. Remember, this was the worst mistake in the history of government. The mistake occurred when we let those guys make loans that will never be collected. The government promised to pay their deposits, so whatever it costs we will have to pay it.” Seidman understood the rule of financial stability, but the lesson did not stick. The projected cost of the 2007–2009 crisis peaked at roughly 100 times the initially-estimated cost of the S&L Crisis. By prompt action, moreover, the entire cost of the 2007–2009 crisis has now been recovered.

The cause of each crisis was identical. The government promised to pay investors in the banks that originated bad loans and purchased millions of mortgages and thousands of mortgage-backed securities. These securities were flawed when written and funded during the decade of market neglect and flawed policy that led to each financial collapse. The legacy of such transactions remains a barrier to economic recovery even today. We must end all forms of off-balance sheet speculation. Whatever the cost may be to fix those transactions, it must be paid.

So it is with all systemic financial crises—a nation’s financial survival is at stake. Whatever it takes to fix the mess must be done. Blame can be sorted later, but the established process of resolution to end a crisis must be undertaken.

Before Mr. Seidman left office Congress passed a 1991 law that included a process empowering U.S. bank regulators to keep financial crises from destroying the economy. In a systemic meltdown, regulators could undertake whatever response was required to save the system. The law provided for reports to Congress when the authority was exercised. Whatever cost was involved, it would be funded, automatically, through increased premiums on insured bank deposits. For a variety of reasons, however, that law proved ineffective in the 2007–2009 crisis.

PENN SQUARE BANK AND THE PARTICIPATION PROBLEM

In the commercial banking world of the early 1980s, another problem arose that is likely to have far greater ramifications in the future than the better known aftermath of the 1980s thrift crisis. That problem is the loan participation debate generated by the failure of Penn Square Bank, a small Oklahoma shopping center bank in the midst of U.S. oil fields. That bank’s failure destroyed two of America’s leading banks and nearly toppled several more.

Global trade patterns funded this particular bubble, as was the case in 2008. To understand how it happened, consider the problem of the OPEC nations that sought to enforce their oil monopoly on the United States, a nation as rich in that resource as almost any on earth. The United States lets the price of its dollar float. When we export dollars to buy oil, if OPEC exporters converted those dollars into other currencies, the excess dollars would drive up the price of other currencies and drive the dollar down. That in turn would reduce the OPEC monopolists’ profits on subsequent sales unless they charge ever-higher prices for oil.

To avoid a drag on profits without having to buy U.S. goods, OPEC monopolists invested in U.S. capital markets—which kept the dollar strong and generated greater liquidity for banks that make loans. This mercantilist process is as old as trade itself, and will become increasingly important to our narrative as we proceed from the worldwide blunders of the 1970s to far greater blunders of the decade from 1998 to 2008.

To expand oil production the United States of course pushed policies favoring loans to domestic oil producers. That greatly expanded Penn Square’s business, to the point where it sought to gain access to other banks’ deposits to make ever more oil patch loans. It is at that point where some unique ramifications arose by virtue of the terms banks use for loan participation agreements.

Loan participations are subordinate loans made to a lead bank—Penn Square, in this case—from other banks (the participants). They are documented using a false form (the sale of a partial asset) because at the time these interbank funding mechanisms were invented banks were prohibited from borrowing on a secured basis for fear of harming the rights of unsecured depositors. Because participation agreements are subordinate to the rights of all of the lead bank’s depositors, the FDIC (as the deposit insurer and statutory receiver of a lead bank) finds participations a convenient way to protect its interests. This preference by the FDIC, of course, ignores the fact that the FDIC insures deposits at all U.S. banks. As such, the FDIC is merely trading its advantage at lead banks for the disadvantage of the participating banks that the FDIC also insures.

Penn Square found many banks willing to provide it with money for oil patch loans because the drag OPEC’s monopoly caused for oil-consuming regions of the country left them with relatively few opportunities to create new loans. Penn Square had plenty of loans to sell and its borrowers found Penn Square able to assure them lots of standby liquidity by creating loans that funded new deposits that the borrowers made at Penn Square.

The participants could have been protected if they insisted on receiving a distinct loan to the ultimate borrower by the creation of a loan syndicate. That, however, was complicated and would have required Penn Square to grant participants direct access to arrangements with Penn Square’s customers—reducing Penn Square’s ability to generate more deposits.

As opposed to a syndicate of lenders, under which each bank makes loans to the customers, in a participation a lead bank merely declares that it has sold a pro rata share of the lead bank’s loan to the participating bank and agrees to share repayments from the customer, pro rata, based on the amount each bank invests. The participations are documented as the sale of part of a loan, but there is no delivery of the note evidencing the loan to the participant, nor is there an agent that holds the loan in trust for each lending bank.

Absent a syndication or actual delivery of the note, sale of part of the loan is a legal impossibility under the U.S. Supreme Court’s 1925 decision discussed earlier. Loan participations are, therefore, incomplete sales. The purported sale “imputes fraud conclusively” under the Supreme Court’s 1925 ruling. Under the Uniform Fraudulent Transfer Act, the buyer can only acquire collateral rights, and then only if it takes proper steps to gain a security interest.

Thus, by nonbanking law, the participant bank made nothing more than an unsecured loan to the lead bank, Penn Square. Under U.S. law adopted after Penn Square went broke, moreover, unsecured loans to an FDIC insured bank are now subordinate to rights of depositors and to the FDIC as successor to depositors’ rights in receivership. Participations were invented in this form long before enactment of state and federal laws that allow banks to achieve the same result as a participation using a secured borrowing, a model that would now meet the standards of the Supreme Court’s 1925 ruling.

Part of the problem in policing the terms of loan participations is that the transactions, which are arguably a fraud, have been blessed and even encouraged by the FDIC and other regulators. Even if it was a fraud, regulators knew they could prevent receivers from asserting fraud claims and could cut off speculative abuses by lead banks that go broke.

All banks accounted for participation activities under regulatory accounting principles, or RAP, until 1989. Structures for participations could be written for most banks, therefore, without fear that the deceptions implicit in the transactions could spread to other institutions. In these limited circumstances, allowing banks to exchange assets and diversify risk by borrowings written as participations, even if they were poorly documented subordinate borrowings by the lead bank, posed no risk to the government (assuming participants remained solvent).

If a participant in the lending relationship went broke, the lead bank still owned the loan and the cash flows from the loan payments. The regulators could sort out the arrangement as the need arose. If the lead bank went bust, the FDIC knew that the participant bank only had an unsecured (and by later law, subordinate) claim against the estate of the lead bank. In Penn Square’s receivership, the FDIC could and did use the deceptions built into the participation documents to the advantage of the insolvent lead bank’s estate and depositors.

Penn Square operated after Regulation Q and other relics of Depression-era controls were largely removed. As lead bank on many oil and gas loans in Oklahoma and Texas during the OPEC oil crises of the 1970s, Penn Square found it could double up on the normal rights of a lead bank by holding large (and therefore largely uninsured) deposits of borrowers.

These deposits were funded, in many cases, by loans that Penn Square participated (sometimes 90 percent or more) to other banks around the nation. Penn Square had all the deposits while participants had funded 90 percent or more of the loans, creating a massive mismatch of actual credit exposure. It was, in a very real sense, nothing but a Ponzi scheme funded with the deposits of other banks.

When Penn Square went into receivership, its loan participation practice allowed a depositor that borrowed from Penn Square to collect the uninsured part of its deposit merely by offsetting against borrowings. That meant borrowers from Penn Square were protected on their deposits in amounts that greatly exceeded the FDIC’s normal insurance limit—even though in economic terms that money belonged to other banks.

When borrowers offset loans to collect the uninsured portions of their Penn Square deposits, participants of course claimed that the FDIC, as Penn Square’s receiver, had to share the deposit offsets, pro rata, as loan proceeds. If the FDIC had agreed, it would have suffered much higher losses than those generated by the borrowers’ recovery of uninsured deposits. It would have also had to turn over the participants’ share (sometimes 90 percent or more) of the offsets, increasing the FDIC’s exposure by a like amount.

So the FDIC told participants that the law gave them no ownership rights or security interest in Penn Square’s loans or the associated deposits. Therefore, participating banks had no right to proceeds of the deposit offsets. Worse yet for participants, since the offsets had paid the loans, the FDIC noted that there was no further participation obligation of Penn Square. This meant that the participant banks would see no further share of the loan payments.

The failure of Penn Square Bank was a horrific event for those in the banking industry that had not abandoned informal participations in favor of the more complicated and legally correct syndication format. This systemic aspect of the Penn Square collapse also explains why then-Fed chairman Paul Volcker tried, unsuccessfully, to convince FDIC Chairman William Isaac to provide open bank assistance that would bail out Penn Square rather than put it in receivership.

The FDIC’s handling of the failure of Penn Square Bank in receivership was a brutal result for participating banks, and each court that considered the case ruled that the FDIC’s position was correct. Participants that had paid for 90 percent of the balance of Penn Square’s loans, thinking they bought 90 percent of the loan rights and cash flows, were left with 90 percent of nothing.

Participant banks were deceived by false forms that regulators approved as convenient for the banks they regulated, then shattered by the powers of those same regulators acting as bank receivers. As we discussed earlier with respect to state receivers for failed banks prior to the 1930s, the FDIC can enforce the true nature of transactions despite fraud committed by a regulated bank (and encouraged by regulators) before receivership.

Receivers “stand in the shoes of” innocent depositors of an insolvent bank who are likewise defrauded. As against other defrauded bank customers, receivers prevail on behalf of depositors because banks are government-sponsored entities for which, as a matter of public policy, the protection of depositors comes first. This is the fundamental legal principle that allows the FDIC to minimize losses when a bank fails, but also creates enormous risks for customers and counterparties of that bank that do not understand the law.

The FDIC’s actions in the Penn Square receivership case pushed several participating banks into receivership —including some large national banks, such as Seafirst in Seattle in 1983 and Continental Illinois National Bank & Trust in Chicago in 1984. “Continental Illinois held a shocking $1 billion in participations from the Oklahoma bank Penn Square, which had ‘grown pathologically,’” Robert Hetzel notes (Hetzel 2009). Another large participating bank, Chase Manhattan, struggled for many years thereafter and finally was merged into another bank.

U.S. banks are now permitted to borrow on a secured basis. So there is no harm at all in changing the forms for these transactions today. Yet in the early 2000s when accounting standard-setters were asked to consider accounting for participations as the subordinate borrowings they are, the FDIC supported maintenance of the deceptions created by deeming participation agreements to be partial sales. Although the FDIC also warned that it would do what it did to participants in the Penn Square loans if those circumstances arose again, the accounting deception was allowed to continue and to be expanded so that any bond owner can today create an off-balance sheet borrowing scam merely by declaring that it made a partial sale of its bonds.

Penn Square Bank’s failure, combined with the thrift crisis of the 1980s, resulted in the revision of banking laws, elimination of a separate insurer of thrift deposits, and tighter regulatory control through the passage of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 and the Federal Deposit Insurance Corporation Improvement Act of 1991. But little or no change was made in the practice of selling participations in assets that are not true sales, either by regulators or the accounting profession.

Accounting standard-setters decided to go along and took no steps to minimize the deceptions inherent in these participations. These rules, moreover, now apply to all bond owners. They allow banks and others to magically generate off-balance sheet liabilities merely by declaring that some entity that pays them cash owns a partial asset despite having nothing more than the lead entity’s unsecured promise of repayment.

Even today, accounting methods for participations allow the same type of frauds that led to the Penn Square disaster. Nobody can say when that dog will once more bite the U.S. economy, but it will surely bite again and cause far more harm than resulted from the Penn Square situation.

The FDIC does not seem to worry that others will abuse this scam to create systemic risk for the United States and the world. The fact that fraud helps the government generate nominal economic growth and avoid losses when banks fail cannot possibly justify this policy position by the FDIC, but that’s a discussion for the next crisis. What started as a closely regulated scam has become an unlimited opportunity for investor deception.

We suggest laughter at this point—the alternative is to become quite sick.

THE REPURCHASE GAME

Another scam was uncovered at an early stage of deregulation when a Kansas City firm, Financial Corp, worked its way into the secondary group of repurchase agreement traders through which the Fed regulates the nation’s money supply. At a time when banks were legally precluded from issuing secured borrowings, regulators created repo agreements in the form of a sale for use only with a specific class of securities—those issued by the federal government and its agencies. They did so wisely, because borrowing against U.S. bonds precludes the damaging effect of forced bond liquidation that could harm the entire Treasury market and disrupt monetary policy.

When applied to other assets and circumstances, however, repos quickly became another form for generating abusive off-balance sheet liability frauds.

The form of agreement in a repo says the asset is sold but the buyer and seller agree to specific repurchase terms using the sale price plus a rate of interest determined by the time period between sale and repurchase, ranging from overnight to the maturity date of the sold asset. In other words, the agreements are sales in name only. The seller retains all risk of the underlying asset by its agreement to repurchase the asset without regard to market value at time of repurchase or if the obligor (e.g., Greece) defaults. ¹ Each and every term is identical to obligations of secured creditors and borrowers —except that many repos are still done without delivery of the underlying assets—making them unsecured loans rather than even superficial sales.

In a case concerning taxation of interest earned on the underlying assets, the U.S. Supreme Court ruled that the obligation of repurchase makes the ostensive seller of assets subject to repurchase in fact retain ownership, as everyone who understands the instruments expected. Except for a loophole by which Lehman Brothers generated a scam known as the Repo 105 (that it reflected as an asset sale for accounting), GAAP (generally accepted accounting principles) accounts for these transactions as borrowings—which they are.

Now, let’s go back to the Kansas City firm. Financial Corp discovered that if it took possession of the securities it was obligated to resell, it could get still more leverage by selling the pledged collateral outright and pocketing the accrued interest portion of the underlying asset. That is to say, it stole the collateral.

When the firm went broke, after trying (unsuccessfully) to claim a privilege against self-incrimination, the head of the firm was forced to tell creditors what happened under limited use immunity. Without the need to use that testimony, authorities soon placed him in jail. Banks were able to recover their money under theft loss insurance, though many insurers amended their policies to eliminate that coverage after those claims were paid. But manipulations, made possible because the form and substance of these transactions are duplicitous, continue to interfere with efforts to stabilize financial markets. Jerry Markham notes that between 1977 and 1985, failures of government bond dealers dealing in repurchase transactions totaled about $1 billion (Markham 2002).

The Repo 105 used by Lehman exemplifies the trouble with any loophole in accounting for finance: money is entirely fungible. Therefore, any loophole eventually attracts enough bad transactions to generate a crisis, even if normal use of the technique is beneficial to the economy.

The loophole used in Repo 105 by Lehman Brothers was exposed and closed, but has now been reshaped as a derivative that preserves the deception. As with loan participation scams, poor accounting for repurchase transactions will eventually come back to bite the United States as more and more trades are written to take advantage of the loophole. Again, one of the aspects of a free society is that people will always try to bend or break the rules created to ensure financial stability. Damage is limited by laws that encourage and enforce remediation on behalf of those harmed.

By law, auditors are required to ensure that financial statements fairly state a firm’s financial condition without regard to GAAP. The only solution that prevents deception is to insist that all transfers that are not complete (or true) sales under the Supreme Court’s 1925 standard must be reported as debt under accounting rules. The appendix provides a worksheet and opinion terms to assist the reader in understanding how to meet the test for a true sale.

UNCONSOLIDATED FINANCE AFFILIATES OF MANUFACTURERS AND HOMEBUILDERS

Under Depression-era rules, the ability of financial firms to hide transactions using subsidiaries led to requirements after 1934 that those subsidiaries be included in consolidated reporting. Since productive sector entities used finance to support manufacturing, however, accounting continued to separate their manufacturing and financial affiliates to avoid confusion.

That was significant to the 1983 development of stand-alone CMOs by homebuilders. It gave innovators a measure of secrecy and market control that, like the temporary monopoly offered to inventors by patents, helped assure their ability to recover development costs. As financial market deregulation progressed, industrial firms were forced to bring their unconsolidated financial subsidiaries onto their balance sheet in the early 1990s, ending the separation of commercial and financial activities.

A few homebuilders, moreover, had created affiliated originators that were licensed to offer government-backed mortgages in the late 1970s. Originating conforming mortgages and selling GSE-guaranteed mortgage-backed securities gave the builders some relief from problems that deregulation and inflation-fighting caused to those builders’ earlier and more traditional associations with local thrifts. Like all thrifts, they suffered as federally mandated changes in deposit rates (to effectuate monetary policy) created housing booms and busts that reinforced the nation’s need to end Regulation Q.

After learning the process of creating and servicing mortgage-backed securities, a few builders found they could defer U.S. taxes by issuing builder bonds that were backed by home mortgages and issued by nonconsolidated finance subsidiaries of the builders. Under then-applicable tax law, if the builder or its subsidiary owned the mortgage, profits on the sale of that home were recognized only as the mortgage principal was paid. Borrowing against the value of the mortgage gave the builder cash to fund new developments while still deferring the profits on earlier home sales.

The builder bond structure was not new. It mimicked formats that predate the Depression. By creating bond liabilities to support the rentention of mortgages that the builders originated for customers, they could defer taxation for, quite literally, decades. That deferral offset some of the adverse impact on home sales caused by the very high mortgage interest rates that resulted when, under Chairman Volcker, the Fed took steps to end the Great Inflation of the 1970s.

The strategy was hidden from some competitors by the fact that builders were not required to consolidate debt of finance subsidiaries. Investment bankers eventually figured out the structures, however, and offered to help other builders join the party. When too many builders took advantage of the tax benefits, Congress eliminated the tax deferral under tax reforms enacted in the late 1980s.

During the regional recession that followed the 1980s thrift bubble/crisis, the builders’ use of special-purpose bond issuing corporations proved beneficial to mortgagors and bond investors. Unlike the stalemate created by inability to reconcile unpaid mortgages with unsustainable mortgage securities after the 2007–2009 crisis, corporate mortgage bond issuers of the 1980s could file for reorganization in bankruptcy. That allowed modification of their mortgage assets and bond liabilities to match underlying borrowers’ ability to pay and maximize the cash available to pay the issuers’ bonds.

Many bondholders, of course, considered this use of the Bankruptcy Code an invasion on their rights. They were wrong, of course, but it would take twenty years to generate a new crisis during which the lack of adequate remediation would prove the point.

THE RISE OF CMO BONDS ISSUED BY HOMEBUILDERS

Tax benefits that later supported research to create stand-alone CMOs were first used to save the builders’ business model from total elimination as mortgage rates hit 17 percent or more in 1981–1982. As the Fed’s policies to end the great inflation of the 1970s succeeded, long-term rates fell rapidly. By the builders’ experience gained issuing builder bonds, training and market opportunity combined in 1983 to open a profit opportunity unlike any other that the builders had seen.

They found an ability to buy government-backed mortgage securities to serve as 100 percent of the collateral needed to sell stand-alone CMOs. Until others caught on, the builders could pay 97 percent of the bond proceeds for collateral, spend 2 percent on structuring costs and walk away from the closing with 1 percent of bond proceeds as pure profits, with no future obligations. The collateral, moreover, if issued a few months before the bond closing, might pay 2 to 3 percent higher interest rates than those paid on the CMO bonds.

It was an opportunity worthy of the label–an Alchemist’s Dream. While the tax benefits originally allowed are no longer available, an opportunity for riskless arbitrage profit arises when normal financial markets are disrupted. A stand-alone CMO can be created without the participation of a monopoly bank or GSE, so it has enormous positive potential for the global economy. It allows nations to end the threat that supports too big to fail bailouts.

Regulators and economists frequently (and properly) refer to shadow banks as somehow evil, but in fact nonbank finance is a very important part of the private economy. Because anyone can create a stand-alone CMO when banks fail to do their job, these private sector innovations are the very structures needed to overcome crises and assure financial stability–provided they are not abused.

Understanding why this innovation only arose when it did (and not earlier) necessitates reflection on the times from many perspectives. Anyone wanting to better understand the structuring details on which we will now focus will find them in The Law and Economics of Financial Markets (Feldkamp, Lane, and Jung 2005). The process is hard to simplify, but here we go:

1. Start with mortgages originated on one new home at a time—they require individual management. Even if well underwritten, it is hard to tell when a particular homeowner will lose his or her job and need to default.
2. Accumulate a pool of loans and a professional manager to cost-average collection and spread the risk of individual default.
3. Build a nationally diversified pool of mortgages with good underwriting, professional loan collection, and insurance to cover normal default risk relating to individual, local, and regional economic slowdowns. The only remaining default risk is a macroeconomic national concern.
4. Add government mortgage payment guarantees that cover catastrophic national economic emergencies, and the remaining risk will relate only to the timing of loan repayment, not to default.

Let’s now pause to restate the timing risk of these bonds—also known as negative convexity. It is very common for home mortgages to require payment in level installments for 30 years, whereby most principal is paid in the later years. Since most homes last far longer than 30 years, these terms are important stabilizers supporting homeownership. Investors in mortgages know that prepayment penalties don’t work well to preclude early payment because millions of consumers are potential victims. Try as one may, it’s impossible to control the risk that locally elected judges will side with voters over distant bankers and ignore prepayment penalties. Indeed, the 2010 Dodd-Frank law has largely prohibited prepayment penalties on first lien mortgages.

Most home mortgages can be prepaid without penalties and borrowers do so very quickly when interest rates fall. Conversely, when interest rates rise, low-rate mortgages almost never prepay. Both alternatives are disliked by investors, who naturally prefer to have a relatively stable maturity for their investments and certainly do not want early payment when rates fall or deferred payment when rates rise.

Think of the homeowner having the right to pay back the loan to the end investor at any time and without penalty. This is negative convexity, discussed in the earlier analysis of companion class scams. It means that even fully guaranteed mortgage securities trade at a rate spread over similar maturity U.S. Treasury obligations that cannot be prepaid, much like a corporate bond that has a call feature will also trade at a higher yield than a piece of straight corporate debt with no call option for the issuer.

Mortgage experts use the spread of newly issued market rate government-guaranteed mortgage-backed securities over 10-year Treasury securities to measure what investors demand at a given time to accept negative convexity risk. Using statistics that date from 1963 (see Figure 9.1 in Chapter 9), that spread has ranged from a tight spread of less than 50 basis points (suggesting a state of housing euphoria) to a wide spread of more than 250 basis points (a housing industry crisis).

More than almost any other factor, it is this spread that establishes demand for housing and mortgages. The math behind this is complex, but any major builder who looks at the chart of this spread points to times of tight spreads as a high point for builders, and vice versa when spreads are wide.

The point of equilibrium in that market seems to be about 150 basis points. When interest rates are expected to rise (or fall), that equilibrium point changes a bit to reflect changing demand, because prepayment and new origination expectations change (mortgages refinance more slowly when rates rise and faster when rates fall). The effect of spreads on housing activity will vary, moreover, depending on the variance in rate paid on a particular security compared to current market rates for new mortgage loans.

For simplicity, a perceived 150 basis point spread for mortgage securities means that an otherwise risk-free new mortgage will bear a yield 1.5 percent per annum higher than a 10-year U.S. Treasury security when the housing side of Adam Smith’s great wheel of circulation is circulating smoothly at its lowest sustainable level of cost.

Now, let’s go back and describe the last two steps for issuing stand-alone CMOs:

5. A simple mortgage security that is bought at a discount rate 2.5 percent per annum above a 10-year Treasury costs far less cash for an investor to buy than the same security would cost at a discount rate representing a 0.5 percent per annum spread.
6. If one can purchase mortgage securities at a 3 percent spread in a crisis, and finance the purchase 100 percent by selling bonds backed only by the mortgage securities, but with different maturities, at an average spread of 1 percent per annum over 10-year Treasuries, either the seller can keep 2 percent per annum or sell more bonds than it costs to purchase the mortgage securities.

That 2 percent difference in the spread between the simple mortgage security and the CMO with multiple bonds of differing maturities is the source of profit that became available to builders that figured out how to create a stand-alone CMO in 1983. They formed bond issuing subsidiaries (with no need for equity, because the bond structure was free of all default risk) that would (1) buy higher rate mortgage securities at 100 percent of the principal of the issued bonds and pocket the annual spread, (2) buy mortgage securities at a discount from principal and sell bonds up to 100 percent of the principal and keep the front end difference, or (3) in some cases, a little of both.

The profit from doing these deals for new mortgage originations rises as the spread between mortgages and Treasury bonds rises. Therefore, more transactions are done as spread rises, creating demand for more mortgages and increasing the amount of money available to build homes. That heightened demand, in turn, causes the spread to fall, until the reduction of profit for doing the transactions sufficiently reduces the number of transactions done to cause spreads to stabilize.

Over time, therefore, a housing market equilibrium is assured by stand-alone CMOs as the volume of transactions is allowed to ebb and flow freely.

The transactions are safe for anyone to create when the only risk is prepayment. They fit the definition of a riskless arbitrage that opens markets to greater competition and efficiency.

In 1983, the processes of U.S. financial regulation and deregulation had reached a point where each of the many market structures necessary for stand-alone CMOs to work existed. Their creation, moreover, was necessary because the U.S. thrift system (on which the Depression-era mortgage system relied) was rapidly disappearing. By luck and hard work, need and opportunity merged.

Where default is not a risk, generating different classes of bonds with different maturities lets investors that want early payment buy the first bonds to be paid and those that want progressively later payments to buy later maturities.

The overall average maturity of all CMOs issued using a pool of mortgages is necessarily the same as the mortgages backing the CMOs. Each class in a CMO, however, demands a smaller premium for negative convexity risk than the underlying mortgage pool. This is because a risk-free stand-alone CMO provides greater repayment certainty to each class by partnering each investor with the holders of the other classes. It is a partnering process that reduces the aggregate negative convexity premium of the aggregate mortgage investment.

Today, any first-year investment banker that sells CMOs has a computer program that will do all calculations for these transactions in less than a minute. When builders invented CMOs in 1983, however, the algorithms needed to translate standard mortgage prepayment experience into cash flows, aggregate the cash flows and allocate them to pay each class of bonds at different payment speeds (so each bond purchaser could be shown how their bond would pay in different circumstances), required several hours of time on the mainframe computers of major Wall Street investment banks.

The formulas that generate CMOs required months of work by PhD mathematicians. Explaining the models in terms the SEC and investors understood required bevies of lawyers and auditors. After the first deals were done, of course, all front-end costs were covered, making sustained equilibrium of the U.S. mortgage market a reasonable and attainable goal.

Because financial firms were required to consolidate debt issued by financial subsidiaries and homebuilders were not, the creative homebuilders that invented the stand-alone CMO were given the advantage of secrecy. That advantage ended, however, after 1986 when the real estate mortgage investment conduits, or REMICs, opened the housing finance market to financial firms and were then deemed exclusive for income tax purposes.

Wall Street firms successfully lobbied Congress to create REMICs as an exception to IRS regulations that sought to restrain issuance of a trust form of CMO invented by New York lawyers for an affiliate of Sears Roebuck & Co. Under the so-called Sears Regs, the IRS imposed double taxation on multiclass mortgage securities issued by passive trusts. This meant that the CMO trust as well as the investor paid taxes on the interest received from the underlying loans. Since stand-alone CMOs issued by affiliates of builders managed taxes by balancing interest income and expenses using consolidated taxation, the Sears Regs did not affect builder issuance of bonds.

Banks and others pushed for a REMIC exception to give them a way to compete for CMO issuance. After an introductory period, however, REMICs were deemed to be the only form for multiple maturity mortgage securities that could avoid the Sears Regs. Exclusivity had the effect of giving the large banks and mortgage GSEs a monopoly.

It is no coincidence, therefore, that REMICs displaced other types of mortgage-backed securities. They became the only viable choice and led to domination of CMO transactions by banks and federal housing finance agencies, the GSEs.

By the exclusivity REMICs required, tax law closed out competition from nonfinancial firms issuing bond forms of CMOs. Even after the IRS recognized that taxpayers should be able to choose structures that passed tax responsibility to participating owners (the check-the-box rules) as long as they maintain consistency, REMICs continue to sustain a monopoly position that favors GSEs a few large U.S. banks. That problem was a major underlying cause of the significant mortgage market disruptions that have occurred since the 1980s.

The too-big-to-fail (TBTF) banks used their cheap funding and other origination advantages gained under 1998 SEC rules to monopolize the loan issuance market, while the housing GSEs dominated the long end of the mortgage bond market with the aid of phony off balance sheet accounting and REMIC exclusivity. As the subprime market expanded, originating TBTF banks with a short-term funding advantage over nonbanks handed off the junk mortgages to the GSEs for the long bond market monopoly.

No private company or issuer of ABS (asset-backed securities) can compete with a GSE, especially when the GSE is allowed to use its government support to speculate, off-balance sheet, on securities where it remains as the ultimate obligor. The GSEs are fully liable, so it is outrageous to suggest that its obligations can be unreported. Yet that is exactly what both major housing finance GSEs (Fannie Mae and Freddie Mac) were allowed to do. It is equivalent to a manufacturer that buys its own debt, repackages it and resells it, then says it’s not liable for its own debt. The only value to such thinking is that it proves, beyond all doubt, that the very concept of an off-balance sheet liability is duplicitous—a fraud.

The TBTF banks gained an advantage in markets for mortgage originations by funding transactions using commercial paper sold to money market funds (by the off-balance sheet abuse of short-term structured investment vehicles, or SIVs). The practice expanded rapidly after the adoption of the SEC’s Rule 2a-7 amendments in 1998. This was a terrible blunder by Washington that guaranteed bank SIVs unlimited access to money market funds as warehouse lenders. That made the TBTF banks monopoly originators that, in turn, sold these mortgages to monopoly GSEs.

Between 1992 and the SEC’s 1998 rule change, there continued to be enough independent competitors in the origination process to assure that there was at least some origination discipline. That ended in 1998.

The next development accelerating a decline in mortgage quality arose after 2001. Using credit default swaps, the giant insurer AIG became guarantor of almost any transaction, with ever-declining quality. That set off a race to the bottom of the quality chain, funded on the long side by the insatiable appetite of international trading partners seeking to export goods to the United States and rebalance their current account surpluses with capital account investments in GSE and TBTF bank mortgage securities that had direct or implicit U.S. government support.

Bradley Borden and David Reiss note that during the first decade of the twenty-first century, Wall Street firms abused the Internal Revenue Service rules regarding the tax exemption of REITS, bringing into question whether the vehicles used were ever properly constructed (Borden and Reiss 2013). Allegations in a 2012 suit filed by the New York attorney general details how loan originators and REMIC sponsors on Wall Street colluded to populate REMICs with mortgages that did not comply with the REMIC rules.

By the early 1990s, builders had largely stepped back from the CMO instruments they had invented. They saw that financial firms were using REMIC CMOs to bid down spreads between newly originated mortgage securities and 10-year Treasury bonds to levels that made the deals less profitable than other opportunities. So the business became monopolized by loopholes and gimmicks that gave large banks and GSEs unlimited leverage opportunities, off-balance sheet, thereby avoiding all regulatory capital rules.

The SEC’s 1998 Rule 2a-7 changes further compounded the problem by granting banks monopsony power over money market funds. Diversified nonbank asset-backed securitizations that had neutralized the pricing power of bank-sponsored conduits between 1992 and 1998 were cut off. The rules subverted asset concentration limits that are supposed to force money market funds to buy no more than 5 percent of assets from a single entity. The SEC’s changes permitted a single bank to be the sole source of credit deficiency support behind 20 or more SIVs and thereby to become the backer of 100 percent of all assets in a money market fund.

It is, therefore, understandable that bank-controlled conduits came to dominate short-term commercial paper (CP) issuance in U.S. financial markets. They recycled a major part of the $67 trillion international and domestic funding behind the series of market bubbles and crashes that occurred in the decade following 1998. It was a situation that not even the inherent stability of CMOs could rectify. ²

Bank regulators, accountants, and the SEC essentially let a few large banks and the GSEs take near-total control of mortgage markets just as the mercantilist instincts of major exporting nations such as China began to flood the United States with unprecedented (and arguably, unneeded) liquidity. America’s massive trade deficits resulted in an equally massive flow of dollars back into the U.S. financial markets, creating a ready supply of liquidity to fuel the boom in mortgage securities. Rate spreads fell as foreign investors flooded U.S. markets to support their own age-old policies of mercantilism. The too-big-to-fail entities began to reduce the quality of underlying loans so they could buy them more cheaply and make front-ended profits. Builders dared not do that, because they were not too-big-to-fail banks and would have gone broke buying back the loans during a slump. So builders elected to profit by creating McMansions that few customers could afford in a mortgage origination process that had gone berserk.

By slipping risk in at the front end and using off-balance sheet liabilities to pretend risk did not exist when selling CMOs, financial firms succeeded in driving a magical product into the ground, along with the world’s economy. As speculators learned how to short low-quality deals using derivatives, the race to the bottom accelerated. By 2008, modern history’s greatest financial invention ended up nearly destroying the global economy.

Good stand-alone CMOs remain beneficial for the issuance of newly originated mortgages under stable market conditions, but only when the transactions are true riskless arbitrages and their use expands (and contracts) as market spreads for sound products dictate—otherwise they become instruments that support deliberate acts of securities fraud. When risky assets infect these transactions, unwinding the structures without the means to forgive or refund fraudulently contracted obligations is well-nigh impossible.

As a consequence, whenever an opportunity for abuse existed, CMOs issued between 1998 and 2008 generally increased market volatility. In their original form CMOs are instruments designed to be held to maturity. That intention cannot be fulfilled when a crisis necessitates the sale of CMOs by the initial holders of the instruments. We now know that when markets are destabilized by abuse, CMOs convert from countercyclical assets to procyclical instruments that intensify market instability. In short, they become weapons of mass destruction.

There is little doubt that Congress and regulators understand what is required. For the past 12 years (at least) proposals to permit restructuring of underwater mortgage loans have been presented to Congress. When a law similar to the one creating REMICs was enacted for the taxation of securities structures backed by nonmortgage financial assets (FASIT), there was no exclusivity provision. As noted above, the rationale of IRS check-the-box rules made REMICs’ exclusivity a vestige of past illogic. Meanwhile, the SEC needs to address the real problem behind the break the buck crisis of 1994, namely the issue of negative convexity, and end the monopoly/monopsony it granted to the largest banks and GSEs with its 1998 Rule 2a-7 amendments.

These are steps in the best interest of creditors, debtors, the United States, and the world, yet Congress and the SEC have refused to do what must be done for at least a decade.