Directors Disappoint by What They Don't Do

FAIR GAME

" Directors Disappoint by What They Don’t Do" By Gretchen Morgenson – Pub. New York Times - May 11, 2013*

Ms. Morgenson:

I'm surprised you didn't include the classic example of ‘Directors Disappointing’ provided by the Board of Directors at Countrywide Financial.

Shouldn't that board have been suspicious of, and more reluctant to approve, Angelo Mozilo's serial changes to his optioned stock liquidation program? Should that board of directors have been less willing to approve and extend the significant corporate 'stock buyback' program, contemporaneous to Mozilo's option sales? And, should that board have recognized it was a buyback program which gave artificial price support to Mozilo's significant sales of his optioned stock? Should the board of directors at Countrywide have been more curious about Countrywide’s mortgage sales (origination) procedures, the risks of mortgage application falsification, and the non-verification of assets and income of mortgage applicants? Should the Countrywide Board of Directors have questioned, and perhaps even requested, the independent audit details for the quality classifications of Countrywide's mortgage investment portfolio. Should the Countrywide Board of Directors have wondered why Stanford Kurland, Angelo Mozilo's heir apparent, abruptly resigned from Countrywide in 2006? (1) An interesting point, Stanford Kurland is a long time friend (and confidant?) of BackRock CEO, Laurence Fink.

It seems Countrywide board members like Kathleen Brown(2) and Henry Cisneros(3) should have had the financial sophistication to be more concerned about what was happening, in general, in the mortgage market, and, in specific, more concerned about what was happening at Countrywide Financial.(4)

Maybe, that board of directors subscribed to former Citibank CEO, Chuck Prince’s business theory. You may recall what Chuck Prince said about the mortgage bubble, ". . . as long as the music is playing, you've got to get up and dance".(5)

But, I think it’s appropriate to ask, should a board of directors be dancing, or should it be calling the tune?

Footnotes:

1. “Kurland left his job as president and chief operating officer of Countrywide in September 2006, just as the housing market began its descent. The previous year, in 2005, he was paid $19.2 million and made an additional $13.7 million by exercising stock options, according to Reuters. See, “Former Countrywide No. 2 Sees Opportunities in Troubled Mortgages” By Matthew Padilla - pub. Orange County Register - June 10, 2008 - at: http://mortgage.ocregister.com/2008/06/10/former-countrywide-no-2-sees-opportunities-in-troubled-mortgages/

Also see: “Inside the Trillionaires’ Club at BlackRock” By Shawn Tully – CNNMoney - August 17, 2009 From “Lesson No 2 When Investments Get Complex, Do Your Homework” at: http://money.cnn.com/2009/08/12/news/companies/blackrock_trillionaires_club.fortune/http://

In late 2006 the company developed a model that put a lower, more realistic number on the incomes subprime borrowers were claiming on their "no doc" loans. The projections were shocking: BlackRock figured that when the loans reset to their new, higher rates in a couple of years, most borrowers would be spending more than half their real incomes on mortgage payments. Foreseeing an avalanche of defaults, BlackRock dumped subprime bonds in early 2007 when the prices were still lofty.

And see, "Those Valley Boys" at: http://www.scribd.com/doc/141134898/Those-Valley-Boys%20http://

2. Kathleen Brown is the sister of, then State of California Attorney General, now California Governor, Jerry Brown. See: Kathleen Brown, Wikipedia: http://en.wikipedia.org/wiki/Kathleen_Brown

3. Henry Cisneros was the Director of The Department of Housing and Urban Development (HUD) during Clinton's first term as president. In that position he was very instrumental in the implementation of Clinton’s Affordable Housing Initiative which is credited with ‘putting enforcement teeth” into Jimmy Carter’s Community Reinvestment Act. see Henry Cisneros, Wikipedia: http://en.wikipedia.org/wiki/Henry_Cisneros

4. “The Tragedy of Countrywide Financial and Angelo Mozilo” By Gary Jacobson pub. Muckety June 28, 2008, at: http://news.muckety.com/2008/06/26/the-tragedy-of-countrywide-financial-and-angelo-mozilo/3712

5. Citigroup Chief Still Bullish on Buy-Outs By Michoyo Nakimoto and David Wighton - pub. Financial Times - July 9,2007. See the quote, at: http://www.ft.com/intl/cms/s/0/80e2987a-2e50-11dc-821c-0000779fd2ac.html#axzz2T5N8MHGw

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

Additional background: Shortly after being inaugurated into his second term as U.S. President, Bill Clinton discusses his Affordable Housing Initiative in a PBS NewsHour interview. “Bill Clinton: Laying the Foundation for The House of Cards”:

Fraud at the GSE's?

I commented on an interesting article published September 14, 2012 in the Wall Street Journal, How Greenspan Misread the Risks at Fannie and Freddie. It’s an article based upon an excerpt (written by James Hagerty) from his new book The Fateful History of Fannie Mae: New Deal Birth to Mortgage Crisis Fall By James R. Hagerty.

My Comment:

In December of 2011 the SEC filed lawsuits against several former executives of Fannie Mae and Freddie Mac. One of the allegations in both of the two lawsuits is that former executives of Fannie and Freddie mis-categorized mortgage loans that were being bought by Fannie and Freddie and that they failed to inform investors and Fannie and Freddie’s regulator [The Office of Federal Housing Enterprise Oversight] of the true number (percentage and value) of Sub-Prime and Alt-A loans they purchased.

So, it’s not that shocking that most people who believed what Fannie and Freddie were telling them didn’t know of the significant default risk.

Only people like Michael Burry(2) Laurence Fink(3) John Paulson(4) and perhaps Stanford Kurland(5) who actually studied (or were aware of) the progressively diminishing mortgage qualification standards as the bubble formed, and who studied (or were aware of) the actual mortgage borrower income statistics, were prescient enough to become alarmed about Fannie and Freddie’s exposure to default risk.

Based upon what Fannie and Freddie were claiming as their mortgage loan quality, It should be no surprise that Alan Greenspan, John McCain, George W. Bush, Treasury Secretary, John Snow and the Office of Federal Housing Enterprise Oversight [OFEO] were more concerned about the impact of credit rate risk and accounting fraud at Fannie Mae and Freddie Mac than they seem to have been about default risk.(6) 

Footnotes:

(1) Reference SEC Website SEC CHARGES FORMER FANNIE MAE AND FREDDIE MAC EXECUTIVES WITH SECURITIES FRAUD.  

(2) Reference, Betting on the Blind Side By Michael Lewis – pub. Vanity Fair Magazine | April 2010. 

(3) Reference, Inside the Trillionaires Club at BlackRock pub. Forbes Magazine August 17, 2009. From the article: 

LESSON 2: When investments get complex, do your homework: 

. . . In late 2006 the company developed a model that put a lower, more realistic number on the incomes subprime borrowers were claiming on their "no doc" loans. The projections were shocking: BlackRock figured that when the loans reset to their new, higher rates in a couple of years, most borrowers would be spending more than half their real incomes on mortgage payments. Foreseeing an avalanche of defaults, BlackRock dumped subprime bonds in early 2007 when the prices were still lofty.

(4) See, John Paulson, Trader Made Billions on Sub-Prime By Gregory Zuckerman pub. Wall Street Journal January 15, 2008. 

(5) See, Stanford Kurland - Former Countrywide No.2 Sees Opportunity in Troubled Mortgages By Matthew Padilla Orange County Register - June 10, 2008.   From the article:  

Q. How did this venture come about?

A. I was somewhat in a state of retirement. I left Countrywide in 2006 after 27 years. From the sidelines, I was watching the mortgage market meltdown and was in communication with associates of mine over what it was going to take to improve or revitalize the mortgage market. Wall Street firms were reaching out to me on whether I had an interest in participating with them. I got a call from the chairman of BlackRock, Laurence Fink, who asked if I would meet a group of executives who were talking about how to address issues in the mortgage market, and they were working with another company (Highfields Capital Management).
I was very receptive to talking to Larry Fink. We had grown up together and have been friends since grade school days.

Q. Where did you and Mr. Fink grow up?

A. We grew up in Van Nuys. That’s the valley. 

(6) See, YouTube video-clip, Timeline: George Bush, John McCain Warn Democrats of Housing Crisis, at:

 

 

 

Recovery, Twisting in the Wind

I find that, when discussing The Shadow Inventory, almost all real estate specialists, lawyers, regulators and many financial analysts can’t tie one very significant cause into the conversation.

The very significant cause that is missed is a rational explanation of why banks and other mortgage investors are so reluctant to liquidate (or renegotiate) bad investments.

Why do they hold significant amounts of mortgage investments which have little hope of being profitable (over the long term)? When a mortgage is in serious default, why don’t mortgage investors accept a ‘short sale’ - and why do they allow a property to go into the potentially higher loss alternative of foreclosure?

I believe the key to understanding why mortgage investors appear to be behaving irrationally, is to understand the implications of the delay in the implementation of Financial Accounting Standard #157 (mark-to-market accounting).(1)

To understand the implications of the delay in the implementation of FAS #157 read an article from the Wall Street Journal titled, Congress Helped Banks Defang Key Rule By Susan Pulliam & Tom McGinty | pub. 6/3/2009.(2)

 Then watch Georgetown University Law Professor, Adam Levitin’s Congressional testimony titled, Federal Regulators Don’t Want to Know . . . (3)

The point that I believe most commenters miss:

The postponement of the implementation of mark-to-market accounting (FAS 157) gives banks and other mortgage (product) investors the opportunity to delay recognition of their market losses until legal ownership of the property changes (foreclosure). Thus, for the investor, the hoped for offset of losses against future revenue is 'the gating factor’ for the liquidation of the shadow inventory.

Most mortgage investors are institutions. These institutions want to delay the recognition of, and the reporting reporting of, any losses to their investors - and to their regulators - for as long as possible.

As Professor Levitin explains in his Congressional testimony, these institutional investors hope to offset losses against income (fees and penalty revenue) over the next decade.

So, the shadow inventory seems to be a consequence of the rational ‘work-out’ in a world in which institutions can carry (and report) highly depreciated assets at (fantasy) origination value.

P.S. I believe in creative destruction.(4)

Footnotes:
1. See Wikipedia Mark-to-Market accounting scroll to, Effect on subprime crisis and Emergency Economic Stabilization Act of 2008, at: http://en.wikipedia.org/wiki/Mark-to-market_accounting
2. Congress Helped Banks Defang Key Rule By Susan Pulliam & Tom McGinty | pub. 6/3/2009. http://online.wsj.com/article/SB124396078596677535.html
3. Georgetown University Law Professor, Adam Levitin’s Congressional testimony titled, Federal Regulators Don’t Want to Know . . . at: http://youtu.be/ibgdgl0PoBw
4. Creative Destruction (Shumpeter) see: http://en.wikipedia.org/wiki/Creative_destruction

End Note: Even some fairly sophisticated observers can’t put the delay in the implementation of FAS 157 into its proper perspective. Why do mortgage investors prefer foreclosure over a short sale? Watch Congressman Bobby Scott (D-VA) question a panel of mortgage professionals asking, ‘Are there things in accounting principals that we need to change to get everybody to do what’s in everybody's best interests?’at:

 Then listen to Thomas Cox, of Main Attorney’s Saving Homes Project, answer Rep. Scott. Mr. Cox emphasizes a different point (the conflict of interest created by servicer fee revenue) in The Short Sale Conundrum - Misaligned Incentives of Mortgage Servicers, at: and when James Kowalski, a Florida Trial Attorney for Saving Home Project, gets his turn he moves to The MERS Mess. Mr. Kawolski explains the increase in the shadow inventory as a documentation problem rather than an accounting problem, at: