It is widely understood that the sophistication and capabilities of electronic products have been increasing much faster than their cost. Ever since the first Texas Instruments calculators, consumers have experienced steadily increasing performance from personal computers and a host of other products such as TVs and GPS equipment, while their unit cost has not increased in proportion, and in some cases has fallen.
Buyers know that the true cost of most electronic equipment, and not just computers, has declined more or less in accordance with the so-called Grosch’s Law: The cost of computing systems increases as the square root of their computational power. In other words, a buyer will get exponentially more performance bang for each additional buck spent on a computer or any gadget with a computer in it.
Now, since electronic systems, sub-systems and components account for an increasing proportion of all weapons platforms from armed helicopters to warships, it follows that, other things being equal, their unit cost should be declining rapidly courtesy of Grosch’s Law. Instead the very opposite is the case: Unit costs in each and every category—combat aircraft, warships, armored fighting vehicles, air-defense radars and the rest—continue to increase. Evidently, other things are not equal. But what things?
First, we must set aside a common but erroneous presumption: the belief that the high cost of military equipment is caused mainly by the oligopolistic nature of military industries—or as they prefer to call themselves, the military aerospace and defense industry. Because relatively few governments buy major military platforms from relatively few large manufacturers, the result is that the normal cost-constraining function of the free market is absent from military purchasing. Contractors can thus charge pretty much whatever they want, it is said, a process presumably facilitated by “revolving door” relationships between the services and their major contractors.
This line of reasoning is popular but explains much less than one would think. Oligopoly there certainly is; competition is weak even in the United States and almost absent in Europe, where national, bi-national or tri-national conglomerates simply own their respective home markets. But inefficiency is not extreme because there is so much scrutiny, starting with the military buyers themselves who need their aircraft to fly and their missiles to hit their targets, while monopolistic extortion is resisted by the U.S. Congress and even by European parliaments. That is why all long-term comparisons show that military industries are not especially profitable. They have done well out of the post-2001 build-up, but they did poorly before that and will no doubt do poorly again when the Iraq war winds down. Many investors systematically avoid military aerospace and defense stocks for the same reason they avoid airline stocks: the glamour greatly exceeds the returns on equity.
The Procurement Paradox
The most obvious real cause of increasing unit costs is the decline in the production rates of weapon systems, which generates negative economies of scale. That decline has been drastic, and so have been the industrial consequences.
Weapon systems were once truly industrial products, mass-produced for the most part, except for oddities like giant, rail-mounted guns. As in all forms of manufacturing, the efficiency of production was increased by investing in more dedicated as opposed to generic assembly lines or batch-production infrastructures, in more automated machinery, more specialized tooling, and in other ways of replacing labor with capital equipment. Even in wartime conditions, when monetary savings are of secondary importance, the efficiency of highly capitalized mass production was still valued, because it increased the supply of weapons and the homogeneity of their performance. Millions of identical rifles produced by assembly-line workers are more valuable to a mass force than individual match-grade weapons forged by highly skilled gunsmiths. Even if budgets were not significantly limited, the supply of skilled labor was, which is what the highly capitalized plant replaced most advantageously. Only the limitations of available production technologies set final limits at any one time on the substitution of capital for labor.
These days, advanced production technologies allow labor-saving investments up to the limit of fully robotic plants, which require labor only for maintenance, not operation. But because so few weapon systems of any given type are purchased, very little investment in advanced production-plant technologies can be economical. In contrast to civilian industry, in which IT-controlled plants and equipment can produce customized as well as classic mass-produced items, most weapon systems are almost entirely made by hand, with a profligate use of costly skilled labor. That in turn generates additional costs: Humans are less reliable than machines, so the greater the manual content of production, the greater the potential for manufacturing errors that require repairs or replacement, or that simply cause disruptive delays.
The contrast between a typical military production plant and its typical civilian counterpart is stark—for example, between armored-combat vehicle factories and ordinary automotive plants. The former consist mostly of empty space within which highly skilled workers can get under, over and inside the combat vehicles as they are assembled one by one. The latter consist of a production line densely packed with automated machinery. A production capacity of 100,000 per year is more or less a minimum for an automobile plant, and 10,000 per year would not be much at all for a truck plant. Yet no armored vehicle is produced in such numbers. Indeed, these numbers exceed typical total production runs of armored vehicles over a period of many years.
The example of fighter jets, illustrated in Table 1, shows the changes in production rates and the implied potential for economies of scale. Even these data, however, overstate the economies of scale that have been obtainable as time has passed, because they ignore the effect of modifications and upgrades introduced to overcome anticipated obsolescence. Each upgrade imposed its own learning curve and caused a temporary loss of production efficiency. The differences between the (Block 1) F-16s of 1978 and the (Block 50/52) F-16s of 2006, for example, are so great that they are scarcely the same aircraft. They certainly have much less in common with each other than did the first and last versions of the Spitfire or Messerschmitt Bf 109.
Nor are fighter aircraft the most extreme case from the viewpoint of diminished production rates and resulting inefficiencies. Bombers are worse still; armored vehicles are worse than bombers; and tanks are worse than armored vehicles—not to mention ships for the Navy.
So the explanation seems simple, and a remedy impossible. If the unit cost of weapon systems continues to increase because too few are purchased for economies of scale to be brought to bear, then the only solution is to produce more of them. But not even the U.S. military could pay for 15,586 F-35 Joint Strike Fighters, an infinitely more elaborate aircraft than the P-51 Mustang ever was. Nor could the Air Force begin to absorb them into any rational order of battle. The Army cannot afford nor use 21,231 Abrams tanks, whose armor and systems are far more elaborate than those of the M4 Sherman tank—which brings us to a second, related thing that is not equal.
The unit costs of weapon systems have continued to increase not just because fewer and fewer are acquired, but also because of their increasing complexity. A vicious circle has long been at work, starting with the recognition that weapon systems are so expensive that few can be acquired. It continues with the reasoning that if few weapon systems can be acquired, those that are acquired must deliver superior performance. To do that, however, requires both macro- and micro-innovations that are costly, so costly that those innovations make weapons even more expensive—so that even fewer are acquired, and so on and on we have gone.
That is not all: The circle has really been a downward spiral from the 1950s to the present, because the time needed to bring innovations into production has expanded, as well. Weapons that will not be fielded for many years must promise even higher performance to hedge against the uncertainties of what competitors might devise. That increases innovation costs, further reducing acquisition numbers and further raising per-unit costs.
Taken together, problems of scale and complexity define the procurement paradox: We have ever more sophisticated weapons, but so few in number because of cost that overall capabilities either stay the same, decrease, or become simply incalculable against novel changes in the threat environment.
Prisoners of Tradition
The procurement paradox, thus defined, explains a great deal about the rising per-unit costs of major military platforms. But it does not explain everything. Often overlooked by those close to the procurement process, and almost completely opaque to most policy officials high and low, are the hidden costs inflicted by the astounding persistence of traditional weapon configurations.
There have been many wars and much technological advancement since 1945, but nothing as revolutionary as a prolonged world war has fully engaged the energies and talents of the developed countries to overthrow old paradigms of war-fighting. The result is that the canonical weapons platforms and configurations of World War II have endured, despite all the new possibilities opened by technological advancements in the past six decades.
The old configurations were a good fit for the technology of 1945. Today, they have become obstacles to military advancement, severely compounding the procurement paradox. Instead of shaping new platform and weapon configurations to fit today’s information technology, communications, sensor and guidance equipment, we are shoving, cramming and molding such technology to fit into the nooks and crannies of 1945-era platforms. Moreover, those traditional platforms mostly retain their 1945 character as autonomously operating units, even though in war they would always operate in groups of near-identical platforms and, increasingly likely, in joint configurations with other kinds of platforms.
For example, airborne radars, including the latest Active Electronically Scanned Arrays, are perhaps a hundred times as expensive pound for pound as even the most elaborate high-definition television sets. But what makes them almost a thousand times more expensive is the need to miniaturize and package the new radars so that they will fit into the nose-cone of fighter aircraft designed for aerodynamic optimality rather than to accommodate equipment as elaborate as today’s best radars.
Given the potentially revolutionary combat value of the new radars, which can not only detect, acquire and track multiple targets but also attack electronic circuitry with highly focused beams, combat aircraft should be designed around them, not the other way around. Even greater cost-effectiveness could be achieved if ensembles of dissimilar combat aircraft were designed around the new technology, some with their own full-scale radars, others with a greater weapons load, others still equipped for defense suppression and so on. We are not doing this. Instead, the latest variants of the F-18 and F-15 aircraft have one radar set, old or new, per nose-cone, just as it was with mechanically scanned radars more than thirty years ago, and just as it was with the first radar-equipped fighters of World War II. Things are no different with the new F-22, and the F-35 Joint Strike Fighter, the future combat aircraft of many air forces. In those designs, as well, the new radar must fit wherever there happens to be room for it, in an aircraft designed according to impeccably traditional, and decreasingly consequential, aerodynamic criteria.
Today’s advanced airborne radar sets are not a unique example. The same is true of most other new equipment and of most platforms. Instead of providing suitable and economical new forms into which the new content can best be accommodated, operated and maintained, the new content is expensively miniaturized, fragmented and contorted so that it can fit into the old classic forms. This not only greatly increases costs; it also constrains effectiveness.
For all the heady talk of advancement and breakthrough technologies, the 1945 platforms have proven amazingly persistent, probably for an entirely irrational, albeit compelling, reason: fond memories of their central role in the war that remains emblematic for the few countries that design, develop and produce the world’s major weapon systems. Whatever the ultimate explanation, the facts are undeniable, as three case studies illustrate: fighter aircraft, tanks and aircraft carriers.
Fighter Aircraft: There were no dedicated fighter aircraft in 1914; only a variety of biplanes (and a triplane or two), none armed. Thanks to the crucible of two world wars, a mere thirty years later an all-metal, jet-propelled monoplane fighter (the Messerschmitt 262) was flying in combat service.
More than sixty years later, in 2007, instead of even more drastic changes to accommodate the IT revolution, networked communications, new sensor technology and so forth, the 1944 configuration has not changed at all. All current and upcoming fighters—the F-15, F-16, F-18, F-22, F-35 JSF, Jaguar, Gripen, Eurofighter, Rafale, MiG-29 and Su-27/30—perpetuate the Me 262 configuration. All feature aerodynamically optimized forms, one or two aircrew, one or two engines and full sets of sensors for self-sufficient operation in both air-to-air and air-to-ground missions (despite the fact that a single fighter aircraft would only ever fly on its own in the immediate aftermath of a very unsuccessful combat operation).
Nobody could ever confuse a 1914 biplane with the Me 262 after thirty years of macro innovation, but after more than sixty years of post-1945 conservatism, only experts and enthusiasts would immediately categorize the Me 262 as anything other than a contemporary aircraft.
Even more important than mere appearance, today’s fighters perpetuate a 1945 conception of air power that views the fighter pilot as an airborne knight with all his weapons on his flying horse, ready to battle the enemy on his own (or sometimes with a second crewman to play the loyal squire). From this conception follows the homogeneity principle: Aircraft of any one type are all equipped the same way, without any effort at task-force optimization—again, despite the fact that fighter aircraft are never sent into action on their own.
Main Battle Tanks: There were no armored fighting vehicles in 1914 except for a handful of very lightly armored cars; for the rest, soldiers only had wheeled trucks and some tractors, none armored or armed. Only thirty years later, the heavily armored main battle tank—manned by a four- or five-man crew and armed with a high-velocity, long-barreled gun in a rotating turret (T-34, Sherman, Tiger)—was operating on a large scale.
More than sixty years later, in 2007, instead of drastic platform innovation to respond to the proliferation of light, armor-piercing weapons and of surface-to-surface missiles, today’s main battle tanks—the M1, T-80, Leopard, AMX-50 and the rest—can all still be easily confused with a Panzerkampfwagen VI Sd.Kfz 182 (“King Tiger”) of 1944. And all still rely on a rotating high-velocity turret gun as their main armament, as if guided missiles had never been invented.
In other respects, too, post-1945 improvements to tanks have only been incremental—not revolutionary, as they were in the tanks of 1944 as compared to those of 1918. Yes, today’s composite armor is more resistant to kinetic penetration than the armor of 1944, pound for pound, but the difference is not qualitative. Acceleration on the battlefield can be somewhat higher, too, because of better suspensions, but it is the difference in fire-control sub-systems that really counts: If potential first-round hit probabilities go way up, acceleration becomes less important. But those sub-systems are expensively and poorly accommodated in modern tanks, which still replicate the canonical World War II configuration, no matter what else about the battlefield has changed.
The only way to explain this is to conjecture that each generation of armor officers since 1944 has demanded incremental improvements on the 1944 design while simultaneously refusing to seriously consider any other configuration. That is exactly what happened, and that is why, instead of offering altogether greater striking power, today’s battle tanks are burdened with ever more active and passive defenses against anti-tank missiles that cost less than a hundredth of those defenses.
Aircraft Carriers: There were no aircraft carriers in 1914, only the British seaplane tender HMS Hermes. Thirty years later, the large-deck aircraft carrier with below-deck hangar space, a small island on top, hydraulic catapults for launching and arrestor cables for recovering aircraft had become the capital ship of the age. The aircraft carrier was greatly valued for its unique ability to convey air power beyond the range limits of combat aircraft in the days before aerial refueling.
Now, 63 years later, that same 1944 configuration remains unchanged in its basic forms despite all subsequent incremental improvements, large and small—from steam catapults to angled decks to nuclear propulsion. More important, aircraft carriers remain the capital ships of the navies that have them, and the envy of those that do not. Yet manned aircraft, as well as missiles and unmanned aircraft, can now have global range, so sea-basing has lost its once indispensable function of bringing short-range aircraft within reach of their targets. Instead it provides a hugely expensive and vulnerable (albeit more versatile) base to attack targets also within reach of other aircraft.
Not coincidentally, the fighter aircraft, main battle tank and aircraft carrier are of central importance institutionally for their respective components of U.S. and other armed forces. Hence the renewal of those specific platforms with ever more perfected versions of the same classic forms greatly preoccupies service organizations, service chiefs and their civilian appendages. There is a veritable culture around each of these weapon configurations, which is of course inherently conservative, as is any culture.
Other platforms and weapons are just as resistant to change as fighter aircraft, tanks and aircraft carriers in ways that increase costs and degrade effectiveness. Three are most interesting for our purposes: the very ancient field artillery, last century’s over-the-beach amphibious vessels and vehicles, and the more recent attack helicopter. All three configurations can still be valuable in combat as specialized equipment acquired in small numbers, but not in the way they are designed and deployed today.
In the case of field artillery, more can be done these days by much cheaper mortars with guided bombs and by geographically more flexible air power. In the case of amphibious vehicles, it is because large-scale amphibious landings in D-Day style are wildly unlikely today. And for good reason. In the 1991 Gulf War, for example, the Marines were forced to cancel the largest landing operation since Inchon in 1950 because fewer than fifty reasonably modern, and quite inexpensive, anti-ship were mines in their way.
In the case of attack helicopters it is because air assaults by massed attack helicopters cannot possibly succeed in modern conditions against armed enemies because of their high vulnerability to contemporary weapons. Case in point: In 2003 the U.S. Army’s AH-64s failed against Iraqi armored forces of low quality, suffering much damage while inflicting little. Large, very noisy machines that cannot fly either fast or high cannot prevail against the contemporary proliferation of ground weapons that can shoot them down, including ordinary machine-guns and hand-held missiles that fixed-wing combat aircraft can over- or out-fly with ease.
In contrast to field artillery and amphibious craft, which served important purposes at one time or another, attack helicopters may well be an outright wrong turn in the evolution of weapons. They always seem to fail in combat against enemies who can shoot back, and have therefore been absent, inconsequential or highly problematic in recent wars. Only their unique institutional value to armies that are not allowed their own fixed-wing combat aircraft can explain why attack helicopters continue to be developed and produced in large numbers.
Overcoming the Procurement Paradox
The only way to overcome the procurement paradox is to pursue macro-innovation in major platforms to make best use of new technology. But thanks to hidebound service cultures, we instead spend fortunes on micro-innovations meant to remedy the obsolescence of old configurations and practically nothing on revolutionary new platforms.
Worse, perhaps, we cling still to the old model of maximum homogeneity in platforms and weapons. There was once a time when mass armies, mass air forces and 2,000-ship navies could only be equipped efficiently with mass-produced equipment, but that has not been true for years. Not only do we rely much less on sheer numbers, but today’s flexible-production technology allows for far more economical customization than we ask of it. If we are going to pay the costs of building weapons more or less by hand, it makes no sense to build them all the same. Indeed, the great variety of available sub-systems favors heterogeneity and mixed task forces because all these sub-systems can be useful, but very few platforms, if any, can include them all.
For example, many kinds of sensors now operate across the electromagnetic spectrum and all sensor data can be securely communicated all the way up and down the chain of command in real time. Therefore, not all platforms need their own identical set of sensors, even if they could accommodate them all. By equipping the individual platforms of air squadrons, tank battalions, missile-boat flotillas and so forth with dissimilar but integrable sensor suites, total sensor costs could be greatly reduced with no significant loss of performance.
Here’s one way to describe the essence of the point: Think of individual weapons platforms not as discrete units, but as fractional, networked parts of a whole. If the conceptual unit of operation is the ensemble of platforms linked together with reliable, real-time communications rather than a individual machine, platform design and function begin to look radically different. We are living at a time when the concept of a distributed system is widely understood. Why we are unable to apply this elemental understanding to weapons design is a reason for wonder, particularly when it is so easy to demonstrate how it can work. Consider the following two examples.
Unmanned Aerial Vehicles. Resistance to one recent macro-innovation—the unmanned aerial vehicle, or UAV—has already been partially overcome, proving that we can do this if we try. The simplest function of a UAV is to fly over enemy territory to observe “the other side of the hill.” This is a requirement so elemental that even the most conservative armies have rushed into service anything that could fly, starting with hot air balloons long before Italy used biplanes in the 1911 conquest of Libya to inaugurate heavier-than-air combat aviation.
Unmanned aerial vehicles are not new: Several kinds were operating in the 1950s and remotely controlled drones were flying long before then. Yet it was not until June 1982 that UAVs were deployed operationally as an integral part of a combat force in war: The Israeli Army’s 162nd Division used observation RPVs (remotely piloted vehicles, as they were then called) in their fight against Syrian forces in Lebanon. The dramatic results of that experience were widely shared with the U.S. Department of Defense. The evidence ought to have been immediately convincing: The actual imagery was taped. Yet here we are in 2007, and the integration of UAVs has only just begun, even in the most advanced armed forces, including those of the United States. How does one explain this?
The most prevalent excuse for resisting anything new is cost, but that excuse cannot be used against UAVs as a category. While one or two types of UAVs are very expensive, most are rather cheap. Nor is there evidence to support the widespread belief that the introduction of pilotless aircraft has been impeded by pilot-dominated command structures. It seems instead that the resistance to UAVs is more a case of diffused institutional resistance to any new platform category that must inevitably be funded at the expense of established ones.
Such determined institutional resistance can be documented. For example, the IAI/TRW Hunter UAV program was cancelled in 1996 after the acquisition of an initial batch because U.S. Army evaluators reported many severe defects: inadequate range, unsatisfactory datalink, too big to fit into the designated transport aircraft, unstable software, and unacceptable engines. After considering (one hopes only perfunctorily) an absurdly expensive $2 billion program to remedy this long list of crippling defects, the planned acquisition was simply cancelled. The cancellation inevitably perpetuated the roles of existing U.S. aviation platforms, notably helicopters and fixed-wing light observation aircraft. Alas, this could not be helped, for the cancellation was seemingly a straightforward matter of rejecting defective equipment.
As it happens, however, the initial batch of entirely unimproved Hunters, supposedly crippled by defects, did not go to waste. In the spring of 1999, eight of the surviving Hunters, redesignated RQ-5A, were sent to Albania in support of Operation Allied Force, the NATO air campaign against Serbia. In the course of 281 sorties (281 sorties for only eight aircraft) the Hunters provided real-time video of conditions on the ground both to commanders on the spot and, via satellite links, to NATO headquarters. Hunter operators identified and located targets for the air campaign and often stayed on station during air strikes to provide real-time damage-assessment, greatly reducing the need for follow-up strikes.
In 2002, Hunters were tested experimentally for ground strike operations, dropping Brilliant Antiarmor Munitions (BATs) to achieve direct hits on tank targets. Later a Hunter was armed with the BAT-derived “Viper Strike” fitted with a laser seeker: Nine drops yielded seven hits. In 2003, the Army used Hunters for scouting, fire-observation, damage assessment and overwatch roles during the invasion and subsequent occupation of Iraq. By mid-2004, when leftover Hunters had flown some 30,000 flight hours—a remarkable demonstration of reliability—another 14 unimproved Hunters were purchased and immediately pressed into service.
The 1996 cancellation of the Hunter program was thus clearly not the result of its shortcomings but of exaggerated or simply unnecessary requirements, all in the service of institutional resistance to new platform configurations. UAVs were not rejected outright but were instead disqualified through the imposition of requirements that were inappropriate for the new configuration—namely, reliability and versatility characteristics of manned aircraft. The bureaucratic kill mechanism worked like this: Adding redundancy for more reliability would increase costs, but something so expensive should carry more than just one sensor. Adding sensors would make the UAV more expensive still, so much so that it should be equipped for safe recovery in all circumstances. A few applications of this line of reasoning soon made UAVs as costly as the equivalent manned platforms or more so, without giving it the versatility of manned platforms. The result, though bad for U.S. military capabilities, was certainly good for the attack helicopter business, on which far more has been spent since the advent of UAVs than on UAVs themselves, and by orders of magnitude.
Today, UAVs have overcome most institutional barriers in the world’s more advanced armed forces. They are likely to be fully accepted when the next necessary step is taken: the deployment of UAVs in groups, as squadrons and fleets operating synergistically, as manned platforms now do. This benchmark will lead to a new requirement: automatic or nearly automatic operation from pre-flight check-out to debriefing downloads. This will happen because once UAVs are deployed as broadly as they should be, they will require so many pilot-rated personnel that it will eventually be necessary to automate them.
Versatile Combat Aircraft. Multi-role fighters gradually became the standard configuration in the 1960s as distinctions between fighter-bomber, interdiction and attack roles grew blurry, thanks to technological change. The technical constraints that had forced sharp choices between these sub-configurations began to erode long before then, but institutional urges prolonged role distinctions. For example, the survival into the 1960s of the pure interceptor aircraft—such as the American F-102 and F-106, or the Soviet Yak series and later the MiG-31—can best be explained by the existence of separate “interceptor” commands like PVO Strany and the USAF Air Defense Command that wanted to select and buy their very own distinctive aircraft.
All this is now past, and it is a major advance to have abandoned obsolete role distinctions that imposed vast costs because of their dissimilar design, development, production, training and maintenance requirements. Now the time has come for another advance, away from tightly packed fighter-size aircraft, in which today’s sensors, communication devices, data processors and displays must be squeezed at great cost, to larger Versatile Combat Aircraft (VCA).
VCAs would be characterized by “plug-and-play” equipment racks and operating stations in the main cabin, longer unrefueled range and much greater endurance than any fighter-sized aircraft. They would, or at least could, also have any or all of the following characteristics:
• fuselage/wing fittings for optional dorsal, lateral and belly antennae;
• internal bay or bays for expendable sensors, ordnance and, possibly, recoverable UAVs;
• “smart” hard points for equipment pods and air-to-air and air-to-surface weapons;
• aerial refueling capability.
To be all that a VCA can be, it could not be smaller than a big executive jet with a stand-up cabin, but it could be as large as a C-5 or Airbus 380. VCAs could not reach supersonic speeds, nor could they be highly maneuverable. But they would have no need of either: The velocity and agility required tactically would be provided by their missiles, so they would not need to be duplicated by the platform itself.
Despite these limits, VCAs would not be particularly vulnerable. As with the VCA’s closest predecessors like the AWACS, J-STAR and Phalcon, all large, non-stealthy, non-agile subsonic aircraft, actual operational vulnerability would be much less than the apparent tactical vulnerability. Combat experience to date shows that, when flying at typical cruise speeds (Mach 0.8) at altitudes well above 30,000 feet, even airliner-type aircraft can usually evade interception by short-range fighters that are not already airborne, as well as protect themselves with electronic countermeasures (to which radars with circuitry-burning power levels could now be added). In addition, VCAs could protect themselves with air-to-air missiles, especially longer-range varieties. In due course, if VCAs are deployed, air-to-air missiles of ultra long-range are likely to be developed for them.
VCAs cannot be cheap, but they could be economical all the same, especially for countries that have geographically expansive operating requirements. The same individual VCA, not merely the same type of aircraft, could quickly be fitted out for any of several different roles. Any airframe can be converted given enough time and money, but the VCA would be designed for such modularity, taking only an hour or two for reconfiguration rather than weeks, months or years. With that kind of designed-in flexibility, VCA roles could include maritime surveillance, classification and surface strike; anti-submarine detection, location and attack; airborne early warning, and beyond-visual-range interception with long-range air-to-air missiles; airborne command, control and tactical direction of air, ground or naval forces; detection and classification of surface targets with Synthetic Aperture Radar; direct attack of surface targets in low-threat environments; detection of low-contrast targets via controlled UAVs; air-defense suppression, ECM and kinetic; airborne refueling, and all forms of electronic intelligence collection and some immediate analysis by on-board specialists and linguists.
The VCA would also be economical in another way. Because the same aircraft could perform functions now compartmentalized among different platforms, their capabilities would be fungible. VCAs could therefore be surged force-wide for any role for which operating crews, equipment and ordnance are available. That would directly offset the most obvious shortcoming of VCAs for smaller countries, that their high unit cost would restrict their numbers.
Beyond that, VCAs could be used synergistically, the same platform working in different roles simultaneously. VCAs fitted out for different roles could offer tactical and operational synergies without sacrificing airframe diversity. Some cost savings would be realized from the commonality in the acquisition, operation and maintenance of the platform itself, which would have the same engines, cockpit, flight-crew training, replacement parts and so on regardless of its role. Still more cost savings would flow from modification and modernization economies. The expense of fitting today’s wide variety of sub-systems and their components into the nooks and crannies of fighter-sized aircraft would disappear, as would the expense of modifying, upgrading or replacing those sub-systems and components within rigid volume and other functional constraints. With VCAs, modifications, upgrades, even total mission modernization or conversions, could be plug-and-play, or at least easily accommodated within the less-constrained main cabin.
For all these reasons, VCAs could advantageously complement or replace almost all current platform types, including fighters, especially for militaries with long-range operating requirements. At present, for the lack of an alternative, such militaries acquire inherently unsuitable jet fighters of very limited range and endurance.
Similar arguments can be made on behalf of a multi-purpose armored combat vehicle, without a main turret gun, to replace main battle tanks and the array of armored personnel carriers that accompany them. And the same reasoning applies to the arsenal ship concept, and to still other platforms for which the needed sub-systems, components and weapons are ready for production.
All such arguments for replacing the canonical systems of World War II predictably will be resisted for understandable but very costly institutional reasons—reasons almost always masked by seemingly reasonable objections focused on some shortcoming or other. Those confronting such objectives should keep in mind that almost every military innovation entails some potential loss of capability. The first arquebuses traded a lower rate of fire and shorter range than longbows in exchange for greater lethality. Their winning advantage, however, was ease of training: The longbow was best learned from childhood, while musketry could be learned in a week, allowing regiments to be raised at will.
For reasons not ultimately very different, UAVs could now advantageously replace more capable manned aircraft. VCAs could now replace fighters, as well as half a dozen specialized aircraft types. Multi-purpose armored combat vehicles could replace the big guns of main battle tanks. And arsenal ships could replace individually cheaper destroyers, as well as complement much more expensive aircraft carriers.
For all the diversity of these new platform configurations, they share in common the fact that the platform is designed to accommodate today’s sub-systems and weapons, instead of the other way around. They also share a design premised on the widespread use of distributed systems. This is the best way, perhaps the only way, to escape from the downward spiral of the procurement paradox. The alternative is escalating unit costs for fewer and fewer platforms, the likely net strategic effect being increasingly ineffectual military power in a world of increasingly unconventional challenges.
Monday, September 17, 2007
Monday, August 27, 2007
Inside the Countrywide Lending Spree
Inside the Countrywide Lending Spree
By GRETCHEN MORGENSON
August 26, 2007
NYT
ON its way to becoming the nation’s largest mortgage lender, the Countrywide Financial Corporation encouraged its sales force to court customers over the telephone with a seductive pitch that seldom varied. “I want to be sure you are getting the best loan possible,” the sales representatives would say.
But providing “the best loan possible” to customers wasn’t always the bank’s main goal, say some former employees. Instead, potential borrowers were often led to high-cost and sometimes unfavorable loans that resulted in richer commissions for Countrywide’s smooth-talking sales force, outsize fees to company affiliates providing services on the loans, and a roaring stock price that made Countrywide executives among the highest paid in America.
Countrywide’s entire operation, from its computer system to its incentive pay structure and financing arrangements, is intended to wring maximum profits out of the mortgage lending boom no matter what it costs borrowers, according to interviews with former employees and brokers who worked in different units of the company and internal documents they provided. One document, for instance, shows that until last September the computer system in the company’s subprime unit excluded borrowers’ cash reserves, which had the effect of steering them away from lower-cost loans to those that were more expensive to homeowners and more profitable to Countrywide.
Now, with the entire mortgage business on tenterhooks and industry practices under scrutiny by securities regulators and banking industry overseers, Countrywide’s money machine is sputtering. So far this year, fearful investors have cut its stock in half. About two weeks ago, the company was forced to draw down its entire $11.5 billion credit line from a consortium of banks because it could no longer sell or borrow against home loans it has made. And last week, Bank of America invested $2 billion for a 16 percent stake in Countrywide, a move that came amid speculation that Countrywide’s survival was in question and that it had become a takeover target — notions that Countrywide publicly disputed.
Homeowners, meanwhile, drawn in by Countrywide sales scripts assuring “the best loan possible,” are behind on their mortgages in record numbers. As of June 30, almost one in four subprime loans that Countrywide services was delinquent, up from 15 percent in the same period last year, according to company filings. Almost 10 percent were delinquent by 90 days or more, compared with last year’s rate of 5.35 percent.
Many of these loans had interest rates that recently reset from low teaser levels to double digits; others carry prohibitive prepayment penalties that have made refinancing impossibly expensive, even before this month’s upheaval in the mortgage markets.
To be sure, Countrywide was not the only lender that sold questionable loans with enormous fees during the housing bubble. And as real estate prices soared, borrowers themselves proved all too eager to participate, even if it meant paying high costs or signing up for a loan with an interest rate that would jump in coming years.
But few companies benefited more from the mortgage mania than Countrywide, among the most aggressive home lenders in the nation. As such, the company is Exhibit A for the lax and, until recently, highly lucrative lending that has turned a once-hot business ice cold and has touched off a housing crisis of historic proportions.
“In terms of being unresponsive to what was happening, to sticking it out the longest, and continuing to justify the garbage they were selling, Countrywide was the worst lender,” said Ira Rheingold, executive director of the National Association of Consumer Advocates. “And anytime states tried to pass responsible lending laws, Countrywide was fighting it tooth and nail.”
Started as Countrywide Credit Industries in New York 38 years ago by Angelo R. Mozilo, a butcher’s son from the Bronx, and David Loeb, a founder of a mortgage banking firm in New York, who died in 2003, the company has become a $500 billion home loan machine with 62,000 employees, 900 offices and assets of $200 billion. Countrywide’s stock price was up 561 percent over the 10 years ended last December.
Mr. Mozilo has ridden this remarkable wave to immense riches, thanks to generous annual stock option grants. Rarely a buyer of Countrywide shares — he has not bought a share since 1987, according to Securities and Exchange Commission filings — he has been a huge seller in recent years. Since the company listed its shares on the New York Stock Exchange in 1984, he has reaped $406 million selling Countrywide stock.
As the subprime mortgage debacle began to unfold this year, Mr. Mozilo’s selling accelerated. Filings show that he made $129 million from stock sales during the last 12 months, or almost one-third of the entire amount he has reaped over the last 23 years. He still holds 1.4 million shares in Countrywide, a 0.24 percent stake that is worth $29.4 million.
“Mr. Mozilo has stated publicly that his current plan recognizes his personal need to diversify some of his assets as he approaches retirement,” said Rick Simon, a Countrywide spokesman. “His personal wealth remains heavily weighted in Countrywide shares, and he is, by far, the leading individual shareholder in the company.”
Mr. Simon said that Mr. Mozilo and other top Countrywide executives were not available for interviews. The spokesman declined to answer a list of questions, saying that he and his staff were too busy.
A former sales representative and several brokers interviewed for this article were granted anonymity because they feared retribution from Countrywide.
AMONG Countrywide’s operations are a bank, overseen by the Office of Thrift Supervision; a broker-dealer that trades United States government securities and sells mortgage-backed securities; a mortgage servicing arm; a real estate closing services company; an insurance company; and three special-purpose vehicles that issue short-term commercial paper backed by Countrywide mortgages.
Last year, Countrywide had revenue of $11.4 billion and pretax income of $4.3 billion. Mortgage banking contributed mightily in 2006, generating $2.06 billion before taxes. In the last 12 months, Countrywide financed almost $500 billion in loans, or around $41 billion a month. It financed 177,000 to 240,000 loans a month during the last 12 months.
Countrywide lends to both prime borrowers — those with sterling credit — and so-called subprime, or riskier, borrowers. Among the $470 billion in loans that Countrywide made last year, 45 percent were conventional nonconforming loans, those that are too big to be sold to government-sponsored enterprises like Fannie Mae or Freddie Mac. Home equity lines of credit given to prime borrowers accounted for 10.2 percent of the total, while subprime loans were 8.7 percent.
Regulatory filings show that, as of last year, 45 percent of Countrywide’s loans carried adjustable rates — the kind of loans that are set to reprice this fall and later, and which are causing so much anxiety among borrowers and investors alike. Countrywide has a huge presence in California: 46 percent of the loans it holds on its books were made there, and 28 percent of the loans it services are there. Countrywide packages most of its loans into securities pools that it sells to investors.
Another big business for Countrywide is loan servicing, the collection of monthly principal and interest payments from borrowers and the disbursement of them to investors. Countrywide serviced 8.2 million loans as of the end of the year; in June the portfolio totaled $1.4 trillion. In addition to the enormous profits this business generates — $660 million in 2006, or 25 percent of its overall earnings — customers of the Countrywide servicing unit are a huge source of leads for its mortgage sales staff, say former employees.
In a mid-March interview on CNBC, Mr. Mozilo said Countrywide was poised to benefit from the spreading crisis in the mortgage lending industry. “This will be great for Countrywide,” he said, “because at the end of the day, all of the irrational competitors will be gone.”
But Countrywide documents show that it, too, was a lax lender. For example, it wasn’t until March 16 that Countrywide eliminated so-called piggyback loans from its product list, loans that permitted borrowers to buy a house without putting down any of their own money. And Countrywide waited until Feb. 23 to stop peddling another risky product, loans that were worth more than 95 percent of a home’s appraised value and required no documentation of a borrower’s income.
As recently as July 27, Countrywide’s product list showed that it would lend $500,000 to a borrower rated C-minus, the second-riskiest grade. As long as the loan represented no more than 70 percent of the underlying property’s value, Countrywide would lend to a borrower even if the person had a credit score as low as 500. (The top score is 850.)
The company would lend even if the borrower had been 90 days late on a current mortgage payment twice in the last 12 months, if the borrower had filed for personal bankruptcy protection, or if the borrower had faced foreclosure or default notices on his or her property.
Such loans were made, former employees say, because they were so lucrative — to Countrywide. The company harvested a steady stream of fees or payments on such loans and busily repackaged them as securities to sell to investors. As long as housing prices kept rising, everyone — borrowers, lenders and investors — appeared to be winners.
One former employee provided documents indicating Countrywide’s minimum profit margins on subprime loans of different sizes. These ranged from 5 percent on small loans of $100,000 to $200,000 to 3 percent on loans of $350,000 to $500,000. But on subprime loans that imposed heavy burdens on borrowers, like high prepayment penalties that persisted for three years, Countrywide’s margins could reach 15 percent of the loan, the former employee said.
Regulatory filings show how much more profitable subprime loans are for Countrywide than higher-quality prime loans. Last year, for example, the profit margins Countrywide generated on subprime loans that it sold to investors were 1.84 percent, versus 1.07 percent on prime loans. A year earlier, when the subprime machine was really cranking, sales of these mortgages produced profits of 2 percent, versus 0.82 percent from prime mortgages. And in 2004, subprime loans produced gains of 3.64 percent, versus 0.93 percent for prime loans.
One reason these loans were so lucrative for Countrywide is that investors who bought securities backed by the mortgages were willing to pay more for loans with prepayment penalties and those whose interest rates were going to reset at higher levels. Investors ponied up because pools of subprime loans were likely to generate a larger cash flow than prime loans that carried lower fixed rates.
As a result, former employees said, the company’s commission structure rewarded sales representatives for making risky, high-cost loans. For example, according to another mortgage sales representative affiliated with Countrywide, adding a three-year prepayment penalty to a loan would generate an extra 1 percent of the loan’s value in a commission. While mortgage brokers’ commissions would vary on loans that reset after a short period with a low teaser rate, the higher the rate at reset, the greater the commission earned, these people said.
Persuading someone to add a home equity line of credit to a loan carried extra commissions of 0.25 percent, according to a former sales representative.
“The whole commission structure in both prime and subprime was designed to reward salespeople for pushing whatever programs Countrywide made the most money on in the secondary market,” the former sales representative said.
CONSIDER an example provided by a former mortgage broker. Say that a borrower was persuaded to take on a $1 million adjustable-rate loan that required the person to pay only a tiny fraction of the real interest rate and no principal during the first year — a loan known in the trade as a pay option adjustable-rate mortgage. If the loan carried a three-year prepayment penalty requiring the borrower to pay six months’ worth of interest at the much higher reset rate of 3 percentage points over the prevailing market rate, Countrywide would pay the broker a $30,000 commission.
When borrowers tried to reduce their mortgage debt, Countrywide cashed in: prepayment penalties generated significant revenue for the company — $268 million last year, up from $212 million in 2005. When borrowers had difficulty making payments, Countrywide cashed in again: late charges produced even more in 2006 — some $285 million.
The company’s incentive system also encouraged brokers and sales representatives to move borrowers into the subprime category, even if their financial position meant that they belonged higher up the loan spectrum. Brokers who peddled subprime loans received commissions of 0.50 percent of the loan’s value, versus 0.20 percent on loans one step up the quality ladder, known as Alternate-A, former brokers said. For years, a software system in Countrywide’s subprime unit that sales representatives used to calculate the loan type that a borrower qualified for did not allow the input of a borrower’s cash reserves, a former employee said.
A borrower who has more assets poses less risk to a lender, and will typically get a better rate on a loan as a result. But, this sales representative said, Countrywide’s software prevented the input of cash reserves so borrowers would have to be pitched on pricier loans. It was not until last September that the company changed this practice, as part of what was called in an internal memo the “Do the Right Thing” campaign.
According to the former sales representative, Countrywide’s big subprime unit also avoided offering borrowers Federal Housing Administration loans, which are backed by the United States government and are less risky. But these loans, well suited to low-income or first-time home buyers, do not generate the high fees that Countrywide encouraged its sales force to pursue.
A few weeks ago, the former sales representative priced a $275,000 loan with a 30-year term and a fixed rate for a borrower putting down 10 percent, with fully documented income, and a credit score of 620. While a F.H.A. loan on the same terms would have carried a 7 percent rate and 0.125 percentage points, Countrywide’s subprime loan for the same borrower carried a rate of 9.875 percent and three additional percentage points.
The monthly payment on the F.H.A. loan would have been $1,829, while Countrywide’s subprime loan generated a $2,387 monthly payment. That amounts to a difference of $558 a month, or $6,696 a year — no small sum for a low-income homeowner.
“F.H.A. loans are the best source of financing for low-income borrowers,” the former sales representative said. So Countrywide’s subprime lending program “is not living up to the promise of providing the best loan programs to its clients,” he said.
Mr. Simon of Countrywide said that Federal Housing Administration loans were becoming a bigger part of the company’s business.
“While they are very useful to some borrowers, F.H.A./V.A. mortgages are extremely difficult to originate in markets with above-average home prices, because the maximum loan amount is so low,” he said. “Countrywide believes F.H.A./V.A. loans are an increasingly important part of its product menu, particularly for the homeownership hopes of low- to moderate-income and minority borrowers we have concentrated on reaching and serving.”
WORKDAYS at Countrywide’s mortgage lending units centered on an intense telemarketing effort, former employees said. It involved chasing down sales leads and hewing to carefully prepared scripts during telephone calls with prospects.
One marketing manual used in Countrywide’s subprime unit during 2005, for example, walks sales representatives through the steps of a successful call. “Step 3, Borrower Information, is where the Account Executive gets on the Oasis of Rapport,” the manual states. “The Oasis of Rapport is the time spent with the client building rapport and gathering information. At this point in the sales cycle, rates, points, and fees are not discussed. The immediate objective is for the Account Executive to get to know the client and look for points of common interest. Use first names with clients as it facilitates a friendly, helpful tone.”
If clients proved to be uninterested, the script provided ways for sales representatives to be more persuasive. Account executives encountering prospective customers who said their mortgage had been paid off, for instance, were advised to ask about a home equity loan. “Don’t you want the equity in your home to work for you?” the script said. “You can use your equity for your advantage and pay bills or get cash out. How does that sound?”
Other documents from the subprime unit also show that Countrywide was willing to underwrite loans that left little disposable income for borrowers’ food, clothing and other living expenses. A different manual states that loans could be written for borrowers even if, in a family of four, they had just $1,000 in disposable income after paying their mortgage bill. A loan to a single borrower could be made even if the person had just $550 left each month to live on, the manual said.
Independent brokers who have worked with Countrywide also say the company does not provide records of their compensation to the Internal Revenue Service on a Form 1099, as the law requires. These brokers say that all other home lenders they have worked with submitted 1099s disclosing income earned from their associations.
One broker who worked with Countrywide for seven years said she never got a 1099.
“When I got ready to do my first year’s taxes I had received 1099s from everybody but Countrywide,” she said. “I called my rep and he said, ‘We’re too big. There’s too many. We don’t do it.’ ”
A different broker supplied an e-mail message from a Countrywide official stating that it was not company practice to submit 1099s. It is unclear why Countrywide apparently chooses not to provide the documents. Countrywide boasts that it is the No. 1 lender to minorities, providing those borrowers with their piece of the American homeownership dream. But it has run into problems with state regulators in New York, who contended that the company overcharged such borrowers for loans. Last December, Countrywide struck an agreement with Eliot Spitzer, then the state attorney general, to compensate black and Latino borrowers to whom it had improperly given high-cost loans in 2004. Under the agreement, Countrywide, which cooperated with the attorney general, agreed to improve its fair-lending monitoring activities and set up a $3 million consumer education program.
But few borrowers of any sort, even the most creditworthy, appear to escape Countrywide’s fee machine. When borrowers close on their loans, they pay fees for flood and tax certifications, appraisals, document preparation, even charges associated with e-mailing documents or using FedEx to send or receive paperwork, according to Countrywide documents. It’s a big business: During the last 12 months, Countrywide did 3.5 million flood certifications, conducted 10.8 million credit checks and 1.3 million appraisals, its filings show. Many of the fees go to its loan closing services subsidiary, LandSafe Inc.
According to dozens of loan documents, LandSafe routinely charges tax service fees of $60, far above what other lenders charge, for information about any outstanding tax obligations of the borrowers. Credit checks can cost $36 at LandSafe, double what others levy. Some Countrywide loans even included fees of $100 to e-mail documents or $45 to ship them overnight. LandSafe also charges borrowers $26 for flood certifications, for which other companies typically charge $12 to $14, according to sales representatives and brokers familiar with the fees.
LAST April, Countrywide customers in Los Angeles filed suit against the company in California state court, contending that it overcharged borrowers by collecting unearned fees in relation to tax service fees and flood certification charges. These markups were not disclosed to borrowers, the lawsuit said.
Appraisals are another profit center for Countrywide, brokers said, because it often requires more than one appraisal on properties, especially if borrowers initially choose not to use the company’s own internal firm. Appraisal fees at Countrywide totaled $137 million in 2006, up from $110 million in the previous year. Credit report fees were $74 million last year, down slightly from 2005.
All of those fees may soon be part of what Countrywide comes to consider the good old days. The mortgage market has cooled, and so have the company’s fortunes. Mr. Mozilo remains undaunted, however.
In an interview with CNBC on Thursday, he conceded that Countrywide’s balance sheet had to be strengthened. “But at the end of the day we could be doing very substantial volumes for high-quality loans,” he said, “because there is nobody else in town.”
By GRETCHEN MORGENSON
August 26, 2007
NYT
ON its way to becoming the nation’s largest mortgage lender, the Countrywide Financial Corporation encouraged its sales force to court customers over the telephone with a seductive pitch that seldom varied. “I want to be sure you are getting the best loan possible,” the sales representatives would say.
But providing “the best loan possible” to customers wasn’t always the bank’s main goal, say some former employees. Instead, potential borrowers were often led to high-cost and sometimes unfavorable loans that resulted in richer commissions for Countrywide’s smooth-talking sales force, outsize fees to company affiliates providing services on the loans, and a roaring stock price that made Countrywide executives among the highest paid in America.
Countrywide’s entire operation, from its computer system to its incentive pay structure and financing arrangements, is intended to wring maximum profits out of the mortgage lending boom no matter what it costs borrowers, according to interviews with former employees and brokers who worked in different units of the company and internal documents they provided. One document, for instance, shows that until last September the computer system in the company’s subprime unit excluded borrowers’ cash reserves, which had the effect of steering them away from lower-cost loans to those that were more expensive to homeowners and more profitable to Countrywide.
Now, with the entire mortgage business on tenterhooks and industry practices under scrutiny by securities regulators and banking industry overseers, Countrywide’s money machine is sputtering. So far this year, fearful investors have cut its stock in half. About two weeks ago, the company was forced to draw down its entire $11.5 billion credit line from a consortium of banks because it could no longer sell or borrow against home loans it has made. And last week, Bank of America invested $2 billion for a 16 percent stake in Countrywide, a move that came amid speculation that Countrywide’s survival was in question and that it had become a takeover target — notions that Countrywide publicly disputed.
Homeowners, meanwhile, drawn in by Countrywide sales scripts assuring “the best loan possible,” are behind on their mortgages in record numbers. As of June 30, almost one in four subprime loans that Countrywide services was delinquent, up from 15 percent in the same period last year, according to company filings. Almost 10 percent were delinquent by 90 days or more, compared with last year’s rate of 5.35 percent.
Many of these loans had interest rates that recently reset from low teaser levels to double digits; others carry prohibitive prepayment penalties that have made refinancing impossibly expensive, even before this month’s upheaval in the mortgage markets.
To be sure, Countrywide was not the only lender that sold questionable loans with enormous fees during the housing bubble. And as real estate prices soared, borrowers themselves proved all too eager to participate, even if it meant paying high costs or signing up for a loan with an interest rate that would jump in coming years.
But few companies benefited more from the mortgage mania than Countrywide, among the most aggressive home lenders in the nation. As such, the company is Exhibit A for the lax and, until recently, highly lucrative lending that has turned a once-hot business ice cold and has touched off a housing crisis of historic proportions.
“In terms of being unresponsive to what was happening, to sticking it out the longest, and continuing to justify the garbage they were selling, Countrywide was the worst lender,” said Ira Rheingold, executive director of the National Association of Consumer Advocates. “And anytime states tried to pass responsible lending laws, Countrywide was fighting it tooth and nail.”
Started as Countrywide Credit Industries in New York 38 years ago by Angelo R. Mozilo, a butcher’s son from the Bronx, and David Loeb, a founder of a mortgage banking firm in New York, who died in 2003, the company has become a $500 billion home loan machine with 62,000 employees, 900 offices and assets of $200 billion. Countrywide’s stock price was up 561 percent over the 10 years ended last December.
Mr. Mozilo has ridden this remarkable wave to immense riches, thanks to generous annual stock option grants. Rarely a buyer of Countrywide shares — he has not bought a share since 1987, according to Securities and Exchange Commission filings — he has been a huge seller in recent years. Since the company listed its shares on the New York Stock Exchange in 1984, he has reaped $406 million selling Countrywide stock.
As the subprime mortgage debacle began to unfold this year, Mr. Mozilo’s selling accelerated. Filings show that he made $129 million from stock sales during the last 12 months, or almost one-third of the entire amount he has reaped over the last 23 years. He still holds 1.4 million shares in Countrywide, a 0.24 percent stake that is worth $29.4 million.
“Mr. Mozilo has stated publicly that his current plan recognizes his personal need to diversify some of his assets as he approaches retirement,” said Rick Simon, a Countrywide spokesman. “His personal wealth remains heavily weighted in Countrywide shares, and he is, by far, the leading individual shareholder in the company.”
Mr. Simon said that Mr. Mozilo and other top Countrywide executives were not available for interviews. The spokesman declined to answer a list of questions, saying that he and his staff were too busy.
A former sales representative and several brokers interviewed for this article were granted anonymity because they feared retribution from Countrywide.
AMONG Countrywide’s operations are a bank, overseen by the Office of Thrift Supervision; a broker-dealer that trades United States government securities and sells mortgage-backed securities; a mortgage servicing arm; a real estate closing services company; an insurance company; and three special-purpose vehicles that issue short-term commercial paper backed by Countrywide mortgages.
Last year, Countrywide had revenue of $11.4 billion and pretax income of $4.3 billion. Mortgage banking contributed mightily in 2006, generating $2.06 billion before taxes. In the last 12 months, Countrywide financed almost $500 billion in loans, or around $41 billion a month. It financed 177,000 to 240,000 loans a month during the last 12 months.
Countrywide lends to both prime borrowers — those with sterling credit — and so-called subprime, or riskier, borrowers. Among the $470 billion in loans that Countrywide made last year, 45 percent were conventional nonconforming loans, those that are too big to be sold to government-sponsored enterprises like Fannie Mae or Freddie Mac. Home equity lines of credit given to prime borrowers accounted for 10.2 percent of the total, while subprime loans were 8.7 percent.
Regulatory filings show that, as of last year, 45 percent of Countrywide’s loans carried adjustable rates — the kind of loans that are set to reprice this fall and later, and which are causing so much anxiety among borrowers and investors alike. Countrywide has a huge presence in California: 46 percent of the loans it holds on its books were made there, and 28 percent of the loans it services are there. Countrywide packages most of its loans into securities pools that it sells to investors.
Another big business for Countrywide is loan servicing, the collection of monthly principal and interest payments from borrowers and the disbursement of them to investors. Countrywide serviced 8.2 million loans as of the end of the year; in June the portfolio totaled $1.4 trillion. In addition to the enormous profits this business generates — $660 million in 2006, or 25 percent of its overall earnings — customers of the Countrywide servicing unit are a huge source of leads for its mortgage sales staff, say former employees.
In a mid-March interview on CNBC, Mr. Mozilo said Countrywide was poised to benefit from the spreading crisis in the mortgage lending industry. “This will be great for Countrywide,” he said, “because at the end of the day, all of the irrational competitors will be gone.”
But Countrywide documents show that it, too, was a lax lender. For example, it wasn’t until March 16 that Countrywide eliminated so-called piggyback loans from its product list, loans that permitted borrowers to buy a house without putting down any of their own money. And Countrywide waited until Feb. 23 to stop peddling another risky product, loans that were worth more than 95 percent of a home’s appraised value and required no documentation of a borrower’s income.
As recently as July 27, Countrywide’s product list showed that it would lend $500,000 to a borrower rated C-minus, the second-riskiest grade. As long as the loan represented no more than 70 percent of the underlying property’s value, Countrywide would lend to a borrower even if the person had a credit score as low as 500. (The top score is 850.)
The company would lend even if the borrower had been 90 days late on a current mortgage payment twice in the last 12 months, if the borrower had filed for personal bankruptcy protection, or if the borrower had faced foreclosure or default notices on his or her property.
Such loans were made, former employees say, because they were so lucrative — to Countrywide. The company harvested a steady stream of fees or payments on such loans and busily repackaged them as securities to sell to investors. As long as housing prices kept rising, everyone — borrowers, lenders and investors — appeared to be winners.
One former employee provided documents indicating Countrywide’s minimum profit margins on subprime loans of different sizes. These ranged from 5 percent on small loans of $100,000 to $200,000 to 3 percent on loans of $350,000 to $500,000. But on subprime loans that imposed heavy burdens on borrowers, like high prepayment penalties that persisted for three years, Countrywide’s margins could reach 15 percent of the loan, the former employee said.
Regulatory filings show how much more profitable subprime loans are for Countrywide than higher-quality prime loans. Last year, for example, the profit margins Countrywide generated on subprime loans that it sold to investors were 1.84 percent, versus 1.07 percent on prime loans. A year earlier, when the subprime machine was really cranking, sales of these mortgages produced profits of 2 percent, versus 0.82 percent from prime mortgages. And in 2004, subprime loans produced gains of 3.64 percent, versus 0.93 percent for prime loans.
One reason these loans were so lucrative for Countrywide is that investors who bought securities backed by the mortgages were willing to pay more for loans with prepayment penalties and those whose interest rates were going to reset at higher levels. Investors ponied up because pools of subprime loans were likely to generate a larger cash flow than prime loans that carried lower fixed rates.
As a result, former employees said, the company’s commission structure rewarded sales representatives for making risky, high-cost loans. For example, according to another mortgage sales representative affiliated with Countrywide, adding a three-year prepayment penalty to a loan would generate an extra 1 percent of the loan’s value in a commission. While mortgage brokers’ commissions would vary on loans that reset after a short period with a low teaser rate, the higher the rate at reset, the greater the commission earned, these people said.
Persuading someone to add a home equity line of credit to a loan carried extra commissions of 0.25 percent, according to a former sales representative.
“The whole commission structure in both prime and subprime was designed to reward salespeople for pushing whatever programs Countrywide made the most money on in the secondary market,” the former sales representative said.
CONSIDER an example provided by a former mortgage broker. Say that a borrower was persuaded to take on a $1 million adjustable-rate loan that required the person to pay only a tiny fraction of the real interest rate and no principal during the first year — a loan known in the trade as a pay option adjustable-rate mortgage. If the loan carried a three-year prepayment penalty requiring the borrower to pay six months’ worth of interest at the much higher reset rate of 3 percentage points over the prevailing market rate, Countrywide would pay the broker a $30,000 commission.
When borrowers tried to reduce their mortgage debt, Countrywide cashed in: prepayment penalties generated significant revenue for the company — $268 million last year, up from $212 million in 2005. When borrowers had difficulty making payments, Countrywide cashed in again: late charges produced even more in 2006 — some $285 million.
The company’s incentive system also encouraged brokers and sales representatives to move borrowers into the subprime category, even if their financial position meant that they belonged higher up the loan spectrum. Brokers who peddled subprime loans received commissions of 0.50 percent of the loan’s value, versus 0.20 percent on loans one step up the quality ladder, known as Alternate-A, former brokers said. For years, a software system in Countrywide’s subprime unit that sales representatives used to calculate the loan type that a borrower qualified for did not allow the input of a borrower’s cash reserves, a former employee said.
A borrower who has more assets poses less risk to a lender, and will typically get a better rate on a loan as a result. But, this sales representative said, Countrywide’s software prevented the input of cash reserves so borrowers would have to be pitched on pricier loans. It was not until last September that the company changed this practice, as part of what was called in an internal memo the “Do the Right Thing” campaign.
According to the former sales representative, Countrywide’s big subprime unit also avoided offering borrowers Federal Housing Administration loans, which are backed by the United States government and are less risky. But these loans, well suited to low-income or first-time home buyers, do not generate the high fees that Countrywide encouraged its sales force to pursue.
A few weeks ago, the former sales representative priced a $275,000 loan with a 30-year term and a fixed rate for a borrower putting down 10 percent, with fully documented income, and a credit score of 620. While a F.H.A. loan on the same terms would have carried a 7 percent rate and 0.125 percentage points, Countrywide’s subprime loan for the same borrower carried a rate of 9.875 percent and three additional percentage points.
The monthly payment on the F.H.A. loan would have been $1,829, while Countrywide’s subprime loan generated a $2,387 monthly payment. That amounts to a difference of $558 a month, or $6,696 a year — no small sum for a low-income homeowner.
“F.H.A. loans are the best source of financing for low-income borrowers,” the former sales representative said. So Countrywide’s subprime lending program “is not living up to the promise of providing the best loan programs to its clients,” he said.
Mr. Simon of Countrywide said that Federal Housing Administration loans were becoming a bigger part of the company’s business.
“While they are very useful to some borrowers, F.H.A./V.A. mortgages are extremely difficult to originate in markets with above-average home prices, because the maximum loan amount is so low,” he said. “Countrywide believes F.H.A./V.A. loans are an increasingly important part of its product menu, particularly for the homeownership hopes of low- to moderate-income and minority borrowers we have concentrated on reaching and serving.”
WORKDAYS at Countrywide’s mortgage lending units centered on an intense telemarketing effort, former employees said. It involved chasing down sales leads and hewing to carefully prepared scripts during telephone calls with prospects.
One marketing manual used in Countrywide’s subprime unit during 2005, for example, walks sales representatives through the steps of a successful call. “Step 3, Borrower Information, is where the Account Executive gets on the Oasis of Rapport,” the manual states. “The Oasis of Rapport is the time spent with the client building rapport and gathering information. At this point in the sales cycle, rates, points, and fees are not discussed. The immediate objective is for the Account Executive to get to know the client and look for points of common interest. Use first names with clients as it facilitates a friendly, helpful tone.”
If clients proved to be uninterested, the script provided ways for sales representatives to be more persuasive. Account executives encountering prospective customers who said their mortgage had been paid off, for instance, were advised to ask about a home equity loan. “Don’t you want the equity in your home to work for you?” the script said. “You can use your equity for your advantage and pay bills or get cash out. How does that sound?”
Other documents from the subprime unit also show that Countrywide was willing to underwrite loans that left little disposable income for borrowers’ food, clothing and other living expenses. A different manual states that loans could be written for borrowers even if, in a family of four, they had just $1,000 in disposable income after paying their mortgage bill. A loan to a single borrower could be made even if the person had just $550 left each month to live on, the manual said.
Independent brokers who have worked with Countrywide also say the company does not provide records of their compensation to the Internal Revenue Service on a Form 1099, as the law requires. These brokers say that all other home lenders they have worked with submitted 1099s disclosing income earned from their associations.
One broker who worked with Countrywide for seven years said she never got a 1099.
“When I got ready to do my first year’s taxes I had received 1099s from everybody but Countrywide,” she said. “I called my rep and he said, ‘We’re too big. There’s too many. We don’t do it.’ ”
A different broker supplied an e-mail message from a Countrywide official stating that it was not company practice to submit 1099s. It is unclear why Countrywide apparently chooses not to provide the documents. Countrywide boasts that it is the No. 1 lender to minorities, providing those borrowers with their piece of the American homeownership dream. But it has run into problems with state regulators in New York, who contended that the company overcharged such borrowers for loans. Last December, Countrywide struck an agreement with Eliot Spitzer, then the state attorney general, to compensate black and Latino borrowers to whom it had improperly given high-cost loans in 2004. Under the agreement, Countrywide, which cooperated with the attorney general, agreed to improve its fair-lending monitoring activities and set up a $3 million consumer education program.
But few borrowers of any sort, even the most creditworthy, appear to escape Countrywide’s fee machine. When borrowers close on their loans, they pay fees for flood and tax certifications, appraisals, document preparation, even charges associated with e-mailing documents or using FedEx to send or receive paperwork, according to Countrywide documents. It’s a big business: During the last 12 months, Countrywide did 3.5 million flood certifications, conducted 10.8 million credit checks and 1.3 million appraisals, its filings show. Many of the fees go to its loan closing services subsidiary, LandSafe Inc.
According to dozens of loan documents, LandSafe routinely charges tax service fees of $60, far above what other lenders charge, for information about any outstanding tax obligations of the borrowers. Credit checks can cost $36 at LandSafe, double what others levy. Some Countrywide loans even included fees of $100 to e-mail documents or $45 to ship them overnight. LandSafe also charges borrowers $26 for flood certifications, for which other companies typically charge $12 to $14, according to sales representatives and brokers familiar with the fees.
LAST April, Countrywide customers in Los Angeles filed suit against the company in California state court, contending that it overcharged borrowers by collecting unearned fees in relation to tax service fees and flood certification charges. These markups were not disclosed to borrowers, the lawsuit said.
Appraisals are another profit center for Countrywide, brokers said, because it often requires more than one appraisal on properties, especially if borrowers initially choose not to use the company’s own internal firm. Appraisal fees at Countrywide totaled $137 million in 2006, up from $110 million in the previous year. Credit report fees were $74 million last year, down slightly from 2005.
All of those fees may soon be part of what Countrywide comes to consider the good old days. The mortgage market has cooled, and so have the company’s fortunes. Mr. Mozilo remains undaunted, however.
In an interview with CNBC on Thursday, he conceded that Countrywide’s balance sheet had to be strengthened. “But at the end of the day we could be doing very substantial volumes for high-quality loans,” he said, “because there is nobody else in town.”
Wednesday, August 22, 2007
Rate Cuts Won't Cure Ailing Market
Ben Bernanke and his Fed cohorts will get cheap money flowing with a series of interest-rate cuts. But that won't fix the credit crunch.
By Jon Markman 8.23.07
In a country whose populist heroes are kick-ass rebels Jack Bauer, Jason Bourne and Bart Simpson, it is perhaps only fitting that our latest would-be real-world savior is an economist and banker whose monkish beard makes him look almost countercultural.
Unlike his fictional counterparts who always save the day with a snappy remark or a chop to the throat, Federal Reserve chief Ben Bernanke is working from a terrible script that is doomed. He seems like such a nice man that it's a pity he could go down in history as the first one-term Fed chief in decades, not to mention the accidental steward of one of the world economic system's darkest periods.
It's going to take me a few moments to explain, so bear with me. Here's the problem: Last Friday, Bernanke earned a round of applause from the media by bowing to White House and Wall Street pressure and slashing the rate that the Fed charges the nation's least-creditworthy commercial banks for loans from the public till. He also allowed these sketchy banks to put up their worst loans as collateral and radically lengthened the time that they are permitted to hold onto these borrowings from the standard single day to a month or more.
In doing so, the common belief is that Bernanke provided a much-needed shot of adrenaline to the financial system. Yet this medical metaphor, which seems so apt, really misses the point. What the Fed really did was perform an imperfect version of the Heimlich maneuver on the credit markets, dislodging a blockage in one section of its windpipe only to allow the chicken bone to embed itself more firmly elsewhere.
The Fed is now about to embark on a long series of interest-rate cuts in the face of a global economic slowdown, but it has no proof that cheaper money can, by itself, unwind the worldwide credit crunch.
It could work if Bernanke and other U.S. financial officials are able to persuade the biggest institutional investors here and overseas that it will work. Or it could end up lighting an inflationary brush fire that combines with a recession to create the perfect storm of unending investor pain.
All I can tell you is that the last time this was tried in a pre-contraction environment, it failed miserably. From January 2001 to June 2003, the federal funds rate fell from 6.5% to 1% even as the S&P 500 ($INX) fell by 26%, from 1,320 to 976. The lesson: An earnings collapse beats low interest rates every time.
Bring on the pain
Some veteran market observers have remarked that if the Fed had not cut the rate it charges at its "discount window" to 5.75% from 6.25%, providing the illusion of more liquidity, the Dow Jones Industrial Average ($INDU) could have crashed 1,000 points on Friday or Monday.
Well, this may sound harsh, but in the fullness of time we may pine for the crash. Because instead of a short-term crisis that would have wiped out a few overleveraged hedge funds, brokerages and individuals -- causing terrible pain to innocents as well, no doubt -- we may instead wind up with a debt debacle that stretches on for years and years and harms many more.
The plain fact of the matter is that every few decades since the dawn of paper money, long periods of outstanding economic growth have led complacent noblemen, companies, governments and private citizens to borrow large sums amid boundless optimism that that they will pay the principal and interest back on time. Inevitably, reality has caught up with these sponges at the worst possible moment, and they have been forced to surrender their collateral and pride.
Talk back: Time to bring back debtors prison?
In ancient times, creditors were often permitted to torture debtors, and up to the mid-1800s debtors prison was the destination for irresponsible borrowers.
Exploding packages
Today the situation is quite different in a fascinating way. Blame for bad risk-taking is so spread out, and collateral so ephemeral, it's hard to know whom to punish and what to seize. Even as recently as the 1980s, thrifts took real balance-sheet risk by providing mortgages to individuals.
There were loan officers whose jobs were on the line if they made bad loans, and regulators scrutinized the process. In the last housing bust, several S&L chiefs went to jail for their roles in fraud and mismanagement.
Oh, for the good old days -- a much simpler time before financial engineers figured out, with evil genius, how to distribute risk more widely. In the mid-2000s, when money became super-cheap under former Fed Chairman Alan Greenspan, S&L officers were replaced by mortgage "originators" who were paid merely on volume and were not graded by the after-sale performance of their loans.
Continued: A global game of hot potato
These loans were then distributed to banks such as Wells Fargo (WFC, news, msgs), which in turn sold them to be bundled into securities by brokerages like Bear Stearns (BSC, news, msgs), which in turn repackaged those bundles -- called mortgage-backed securities -- into a new class of financial instruments known as "structured finance" vehicles. These instruments, in some cases known as "collateralized debt obligations," or CDOs, basically smooshed thousands of very high and very low credit risks into a single new income-producing package that could be dolled up enough with marketing, duct tape and pixie dust to earn high marks from credit-rating agencies like Moody's (MCO, news, msgs).
In a global game of hot potato, these income-generating time bombs were then sold to hundreds of hedge-, pension- and money-market-fund managers in Asia, Europe, the Middle East and the United States who had vast pools of money to invest and wanted more yield than they could get from Treasury bills.
I know it sounds crazy, but these CDOs were bought by supposedly sophisticated customers who thought they knew what they were getting, but really had no bloody clue. It didn't really matter for the longest time, when U.S. home prices and incomes were rising and everyone could pay their mortgages. But now that foreclosure rates in parts of California, Florida, Ohio and Michigan are double last year's, home buyers are walking away from their investments. Money has stopped flowing into the humble mortgages underlying so many of these supposedly bulletproof instruments -- undermining the whole house of cards.
Last week, the crisis that led the Fed to act came from the trillion-dollar market for a type of short-term debt known as commercial paper. Buyers of these instruments had suddenly determined that toxic CDOs were being used as collateral in supposedly safe CP, and collectively backed away from the table in a stunning rebuke of issuers.
Said veteran banking analyst Richard Bove in a note to his institutional clients at Punk, Ziegel: The lenders realized "how unbelievably foolish they had been in throwing money after deals that they did not understand; instruments that they had not underwritten; and securities that provided no interest-rate protection against risk."
Cranking up the printing presses
The world cannot run without free-flowing commercial paper, so in order to prevent total worldwide economic collapse, European central banks and the Fed printed an astonishing amount of money -- almost half a trillion bucks -- to flood the zone. Then Bernanke topped it off with the discount-rate cut.
What's wrong with this? It perpetuates the cycle of blamelessness and only prolongs an inevitable splat. As Bove points out, homeowners years ago learned to roll over credit card debt into home-equity loans. Then the rise of negative-amortization home loans allowed people to buy homes with no down payments. Next came "evergreen" loans in which borrowers pay interest but little principal. Then came loans in which lenders actually funded interest costs. More recently have come so-called "covenant light" loans in which borrowers are often allowed to meet their obligations by automatically receiving new loans for the amount of the payment.
Continued: Potential for disaster
Bove notes that the financial system has essentially regressed from one in which borrowers were expected to pay back their debt, to one in which principal was forgotten so long as the interest payments were made, to one in which even interest payments are being refinanced. Now Bernanke has institutionalized this practice by bailing out errant commercial paper holders.
With the growth in total U.S. financial debt outpacing GDP growth, 8.7% to 1.5%, Bove concludes, our economy is not capable of generating the income necessary to meet the debt-repayment requirements. The potential for disaster is mind-blowing, and any steps taken to paper this over are only prolonging the unavoidable wipeout.
My guess is that the Fed will try to inject liquidity into the system many more times over the next few months with scant success. It will take years to unwind this mess, which is probably not a problem that monetary policy, by itself, can solve. On the other hand, who knows? Bernanke could catch a break and pull off a miracle recovery.
So play it like this: The S&P 500 Index is already below its 200-day moving average, which tends to distinguish bullish phases from bearish phases. But the really important uptrend line that traders are watching extends up from 2003 through the 2004 and 2006 lows. So long as the S&P 500 remains above that level, which is 1,370, all is well. A weekly break below that level will lead to cries of the end of the five-year bull market, and they're likely to be correct. So if that occurs, close out your long positions, buy government bonds or government bond exchange-traded funds, and save your physical and mental capital for better times.
If you want to buy something, consider regional banks, which will see their borrowing costs lowered by the Fed at a time when their payouts to customers via passbook savings accounts and CDs will also fall. These were among the few winners in the 2001 rout, so they could work again. You can participate by buying one of the industry's exchange-traded funds: the iShares Dow Jones U.S. Regional Banks (IAT, news, msgs); KBW Regional Banking Index (KRE, news, msgs); or Bank Regional Holders (RKH, news, msgs).
Or you can buy an individual regional bank such as First Busey (BUSE, news, msgs), Virginia Commerce Bancorp (VCBI, news, msgs) or Smithtown Bancorp (SMTB, news, msgs) that have solid long-term records.
Fine Print
To learn more about the Federal Reserve system, visit its Web site. To learn more about structured finance, visit Securitization.net. Learn about the many forms of collateralized debt obligations at Risk Glossary. . . .
To learn more about a debtors prison, check out this page at a Virginia preservation site. Charles Dickens' father was jailed in a debtors prison and the young author was forced to go to work at age 12 in terrible conditions to support his family. This hardship led in part to his literary work.
By Jon Markman 8.23.07
In a country whose populist heroes are kick-ass rebels Jack Bauer, Jason Bourne and Bart Simpson, it is perhaps only fitting that our latest would-be real-world savior is an economist and banker whose monkish beard makes him look almost countercultural.
Unlike his fictional counterparts who always save the day with a snappy remark or a chop to the throat, Federal Reserve chief Ben Bernanke is working from a terrible script that is doomed. He seems like such a nice man that it's a pity he could go down in history as the first one-term Fed chief in decades, not to mention the accidental steward of one of the world economic system's darkest periods.
It's going to take me a few moments to explain, so bear with me. Here's the problem: Last Friday, Bernanke earned a round of applause from the media by bowing to White House and Wall Street pressure and slashing the rate that the Fed charges the nation's least-creditworthy commercial banks for loans from the public till. He also allowed these sketchy banks to put up their worst loans as collateral and radically lengthened the time that they are permitted to hold onto these borrowings from the standard single day to a month or more.
In doing so, the common belief is that Bernanke provided a much-needed shot of adrenaline to the financial system. Yet this medical metaphor, which seems so apt, really misses the point. What the Fed really did was perform an imperfect version of the Heimlich maneuver on the credit markets, dislodging a blockage in one section of its windpipe only to allow the chicken bone to embed itself more firmly elsewhere.
The Fed is now about to embark on a long series of interest-rate cuts in the face of a global economic slowdown, but it has no proof that cheaper money can, by itself, unwind the worldwide credit crunch.
It could work if Bernanke and other U.S. financial officials are able to persuade the biggest institutional investors here and overseas that it will work. Or it could end up lighting an inflationary brush fire that combines with a recession to create the perfect storm of unending investor pain.
All I can tell you is that the last time this was tried in a pre-contraction environment, it failed miserably. From January 2001 to June 2003, the federal funds rate fell from 6.5% to 1% even as the S&P 500 ($INX) fell by 26%, from 1,320 to 976. The lesson: An earnings collapse beats low interest rates every time.
Bring on the pain
Some veteran market observers have remarked that if the Fed had not cut the rate it charges at its "discount window" to 5.75% from 6.25%, providing the illusion of more liquidity, the Dow Jones Industrial Average ($INDU) could have crashed 1,000 points on Friday or Monday.
Well, this may sound harsh, but in the fullness of time we may pine for the crash. Because instead of a short-term crisis that would have wiped out a few overleveraged hedge funds, brokerages and individuals -- causing terrible pain to innocents as well, no doubt -- we may instead wind up with a debt debacle that stretches on for years and years and harms many more.
The plain fact of the matter is that every few decades since the dawn of paper money, long periods of outstanding economic growth have led complacent noblemen, companies, governments and private citizens to borrow large sums amid boundless optimism that that they will pay the principal and interest back on time. Inevitably, reality has caught up with these sponges at the worst possible moment, and they have been forced to surrender their collateral and pride.
Talk back: Time to bring back debtors prison?
In ancient times, creditors were often permitted to torture debtors, and up to the mid-1800s debtors prison was the destination for irresponsible borrowers.
Exploding packages
Today the situation is quite different in a fascinating way. Blame for bad risk-taking is so spread out, and collateral so ephemeral, it's hard to know whom to punish and what to seize. Even as recently as the 1980s, thrifts took real balance-sheet risk by providing mortgages to individuals.
There were loan officers whose jobs were on the line if they made bad loans, and regulators scrutinized the process. In the last housing bust, several S&L chiefs went to jail for their roles in fraud and mismanagement.
Oh, for the good old days -- a much simpler time before financial engineers figured out, with evil genius, how to distribute risk more widely. In the mid-2000s, when money became super-cheap under former Fed Chairman Alan Greenspan, S&L officers were replaced by mortgage "originators" who were paid merely on volume and were not graded by the after-sale performance of their loans.
Continued: A global game of hot potato
These loans were then distributed to banks such as Wells Fargo (WFC, news, msgs), which in turn sold them to be bundled into securities by brokerages like Bear Stearns (BSC, news, msgs), which in turn repackaged those bundles -- called mortgage-backed securities -- into a new class of financial instruments known as "structured finance" vehicles. These instruments, in some cases known as "collateralized debt obligations," or CDOs, basically smooshed thousands of very high and very low credit risks into a single new income-producing package that could be dolled up enough with marketing, duct tape and pixie dust to earn high marks from credit-rating agencies like Moody's (MCO, news, msgs).
In a global game of hot potato, these income-generating time bombs were then sold to hundreds of hedge-, pension- and money-market-fund managers in Asia, Europe, the Middle East and the United States who had vast pools of money to invest and wanted more yield than they could get from Treasury bills.
I know it sounds crazy, but these CDOs were bought by supposedly sophisticated customers who thought they knew what they were getting, but really had no bloody clue. It didn't really matter for the longest time, when U.S. home prices and incomes were rising and everyone could pay their mortgages. But now that foreclosure rates in parts of California, Florida, Ohio and Michigan are double last year's, home buyers are walking away from their investments. Money has stopped flowing into the humble mortgages underlying so many of these supposedly bulletproof instruments -- undermining the whole house of cards.
Last week, the crisis that led the Fed to act came from the trillion-dollar market for a type of short-term debt known as commercial paper. Buyers of these instruments had suddenly determined that toxic CDOs were being used as collateral in supposedly safe CP, and collectively backed away from the table in a stunning rebuke of issuers.
Said veteran banking analyst Richard Bove in a note to his institutional clients at Punk, Ziegel: The lenders realized "how unbelievably foolish they had been in throwing money after deals that they did not understand; instruments that they had not underwritten; and securities that provided no interest-rate protection against risk."
Cranking up the printing presses
The world cannot run without free-flowing commercial paper, so in order to prevent total worldwide economic collapse, European central banks and the Fed printed an astonishing amount of money -- almost half a trillion bucks -- to flood the zone. Then Bernanke topped it off with the discount-rate cut.
What's wrong with this? It perpetuates the cycle of blamelessness and only prolongs an inevitable splat. As Bove points out, homeowners years ago learned to roll over credit card debt into home-equity loans. Then the rise of negative-amortization home loans allowed people to buy homes with no down payments. Next came "evergreen" loans in which borrowers pay interest but little principal. Then came loans in which lenders actually funded interest costs. More recently have come so-called "covenant light" loans in which borrowers are often allowed to meet their obligations by automatically receiving new loans for the amount of the payment.
Continued: Potential for disaster
Bove notes that the financial system has essentially regressed from one in which borrowers were expected to pay back their debt, to one in which principal was forgotten so long as the interest payments were made, to one in which even interest payments are being refinanced. Now Bernanke has institutionalized this practice by bailing out errant commercial paper holders.
With the growth in total U.S. financial debt outpacing GDP growth, 8.7% to 1.5%, Bove concludes, our economy is not capable of generating the income necessary to meet the debt-repayment requirements. The potential for disaster is mind-blowing, and any steps taken to paper this over are only prolonging the unavoidable wipeout.
My guess is that the Fed will try to inject liquidity into the system many more times over the next few months with scant success. It will take years to unwind this mess, which is probably not a problem that monetary policy, by itself, can solve. On the other hand, who knows? Bernanke could catch a break and pull off a miracle recovery.
So play it like this: The S&P 500 Index is already below its 200-day moving average, which tends to distinguish bullish phases from bearish phases. But the really important uptrend line that traders are watching extends up from 2003 through the 2004 and 2006 lows. So long as the S&P 500 remains above that level, which is 1,370, all is well. A weekly break below that level will lead to cries of the end of the five-year bull market, and they're likely to be correct. So if that occurs, close out your long positions, buy government bonds or government bond exchange-traded funds, and save your physical and mental capital for better times.
If you want to buy something, consider regional banks, which will see their borrowing costs lowered by the Fed at a time when their payouts to customers via passbook savings accounts and CDs will also fall. These were among the few winners in the 2001 rout, so they could work again. You can participate by buying one of the industry's exchange-traded funds: the iShares Dow Jones U.S. Regional Banks (IAT, news, msgs); KBW Regional Banking Index (KRE, news, msgs); or Bank Regional Holders (RKH, news, msgs).
Or you can buy an individual regional bank such as First Busey (BUSE, news, msgs), Virginia Commerce Bancorp (VCBI, news, msgs) or Smithtown Bancorp (SMTB, news, msgs) that have solid long-term records.
Fine Print
To learn more about the Federal Reserve system, visit its Web site. To learn more about structured finance, visit Securitization.net. Learn about the many forms of collateralized debt obligations at Risk Glossary. . . .
To learn more about a debtors prison, check out this page at a Virginia preservation site. Charles Dickens' father was jailed in a debtors prison and the young author was forced to go to work at age 12 in terrible conditions to support his family. This hardship led in part to his literary work.
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