Accountable Strategies blog

A blog about accountability issues in the public, private, and nonprofit sectors

Posts Tagged ‘subprime mortgage’

When public projects get too risky

Posted by David Kassel on April 10, 2011

In the March/April issue of Public Administration Review, two academic researchers describe an extraordinary breakdown in public sector management.

In “Waste in the Sewer: The Collapse of Accountability and Transparency in Public Finance in Jefferson County, Alabama,” Michael Howell-Moroney and Jeremy Hall detail a highly risky debt scheme that county officials engaged in, hoping to finance a major sewer project without raising sewer rates.  It didn’t work.

The scheme involved the county’s use of auction rate debt and financial derivative instruments known as rate swaps — yes, the same types of instruments that fueled the subprime mortgage crisis.  The whole thing went awry when the national mortgage crisis hit; and, as of the writing of the article, Jefferson County was on the verge of bankruptcy, unable to pay service on $3.3 billion worth of sewer debt.  Jefferson County is relatively small by national standards, but it holds the sixth highest level of debt of any county in the nation.  If the county were to go bankrupt, it would be the largest municpal bankrupty in U.S. history.

Howell-Moroney and Hall take us step by step through a thicket of poor judgment by private financial institutions, mismanagement and corruption by state and county officials, and a lack of adequate oversight by regulatory authorities.  They tell a compelling story, but it should be noted that  Jefferson County isn’t alone in engaging in risky financial and managerial schemes for public projects, although it appears to have dug itself deeper into a financial and legal mess than most. 

In recent years, municipalities around the country have resorted to novel and often complex financial and managerial arrangements in undertaking similar capital projects.  Often termed “public-private partnerships,” these are strictly business arrangements, and the long-term financial risks are often disproportionately placed on the public sector entities.

I discuss some of these cases in my book, “Managing Public Sector Projects,” such as that of Cranston, Rhode Island, which entered into a 25-year agreement with a contractor to upgrade its wastewater treatment system.  The agreement involved a $48 million up-front cash advance to the city to be paid back over the life of the contract.  Cranston projected it would improve its municipal credit rating due to the contract, but, in fact, the opposite occurred — its bond rating went down.  In the 10-year period following the 1997 contract signing, the city’s sewer rates jumped 55 percent.

In Lynn, Massachusetts, the sewer commission sought a legislative exemption in 1998 from the state’s public works bidding law to undertake a major sewer sewer system and treatment plant upgrade.  The commission ended up with a non-competitive solicitation process for sewer contractors that failed to identify beforehand the specifications of the sewer system it wanted.  The result was the approval of a proposal that was projected by the Massachusetts Inspector General to cost $22 million more than if the process had been competitively bid.

Jefferson County appears to have combined no-bid contracting arrangements with risky financing.  Program specifications were also missing in this case, and the county ended up approving numerous sewer projects that were found to be not required under terms of a consent decree with the Environmental Protection Agency.

To date, 21 Jefferson County employees and private contractors have been indicted by federal prosecutors in connection with the sewer program, according to Howell-Moroney and Hall.  Numerous no-bid contract and change orders were allegedly approved by county officials in exchange for bribes and other favors.  The $10 million to $20 million of additional costs found to have resulted from those alleged instances of fraud and mismanagement was then multiplied many times over by the debacle of the interest swap arrangements.

Howell-Moroney and Hall call for improved interest rate swap regulation and improved financial risk analysis by private-sector ratings agencies.  They also call on public agencies, such as Jefferson County government, to specify clearer goals and objectives in undertaking public projects.

These are worthwhile recommendations.  We’re finding out the hard way not only that there are no easy financial paths to follow in undertaking critically important public sector projects, but those who promise easy fixes are not to be trusted.


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A role for nonprofits in the subprime crisis

Posted by David Kassel on July 21, 2008

Nonprofits have come off looking a lot better in the subprime mortgage scandal than their counterparts in the for-profit banking industry and the federal government, says Rick Cohen of The Nonprofit Quarterly

Cohen maintains that community development corporations (CDCs) and other nonprofit housing development organizations have been careful not to push new homeowners into risky mortgages.  And while the federal government has largely been interested in protecting investors, nonprofit organizations have been busy, trying to help homeowners in trouble. 

Cohen cites the work already done of groups such as Neighborhood Assistance Corporation of America (NACA), which he contends is “among the most aggressive and most successful national nonprofits engaged in refinancing the mortgages of families facing subprime-induced foreclosures.”  In addition, the Center for American Progress in partnership with Enterprise Community Partners has proposed the Great American Dream Stabilization (GARDNS) Fund, to be capitalized by a $10 billion Community Development Block Grant appropriation.  The fund would be used to help low and moderate-income homeowners purchase foreclosed and abandoned properties.

As a January report on the GARDNS Fund plan by the Center for American Progress notes:

…debating whether subprime borrowers were more at fault than unregulated mortgage companies is no more productive than arguing about whether the negligent camper or the neglected forest clearance practices contributed more to the rapid spread of a wildfire-
the first order of business is putting out the fire before it consumes more homes.

Cohen also suggests in “How Foundations Can Heal the Housing Crisis,” that nonprofit charitable foundations will have an increasing role to play in financing the rehabilitiation of abandoned properities across the country due to foreclosures.

Foundations can help now before federal money starts flowing, Cohen suggests, by providing grants to municipalities and nonprofits to begin rehabilitating properties and to manage rental units and rebuild neighborhoods.  Cohen maintains that:

now is the time for them (foundations) – and other organizations with vast tax-exempt endowments – to put billions of their dollars to work as a capital base for groups that are trying to stimulate new investments in financially challenged neighborhoods.

Cohen adds that smaller and medium-sized cities, in particular, that have been hit hard by the property-foreclosure crisis, don’t have access to large foundations with “signficant track records in housing and community-development investment.”

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Saving us from the credit industry

Posted by David Kassel on May 5, 2008

There has been a lot of discussion lately about the need for more regulation of hedge funds and investment banks to prevent another credit crisis from even further damaging the U.S. economy.

But what about another, potentially even darker side of the credit industry–those unscrupulous mortgage, credit card, and other lenders who are slowly drowing the middle class in America in a sea of unpayable debt?  In Making Credit Safer, Elizabeth Warren makes a persuasive case that more regulation is desperately needed in that arena as well.

Warren, a Harvard Law School professor, notes that it is impossible to buy a toaster that has a one-in-five chance of bursting into flames and burning down your house.  But it is possible to refinance your home with a mortgage that has the same one-in-five chance of putting your family out on the street.

In addition, while it is impossible for the seller to change the price on the toaster once you’ve bought it, your credit-card company can triple the price on the credit card you used to finance your purchase, even if you meet all the credit terms.  Products sold in America are regulated by the Consumer Product Safety Commission, but credit products “are regulated by a tattered patchwork of federal and state laws that have failed to adapt to changing markets,”  Warren writes.

Americans turned over $89 billion in fees, interest payments, added costs on purchases and other charges associated with their credit cards.  As Warren notes, that’s $89 billion that didn’t go to new cars, new shoes, or any other goods and services.  And not all of these costs are measured in dollars.  There is also the anxiety and shame that accompany Americans struggling with debt.

Warren makes the case that foolishness and profligacy on the part of those in debt doesn’t explain the entire problem.  Lenders, she notes, “have deliberately built tricks and traps into some credit products so they can ensnare families in a cycle of high-cost debt.”  Credit card interest rates often hover around 30 percent, while so-called Payday loans can have interest rates of nearly 500 percent.

The average credit card contract has become an incomprehensible morass of clauses that culminate, in one case, in the statement by one prominent credit card company that, “We reserve the right to change the terms at any time for any reason.”  Then there are the “yield service premiums” or YSPs that mortgage companies pay to brokers who steer families into high-cost, teaser-rate mortgages.  These YSPs helped drive the wild selling, Warren says, that led to the collapse of the subprime mortgage market.

Congress, under the pressure of the mortgage broker industry has done little so far to curb these abuses.  And the traditional state role in regulating credit card interest rates has been usurped by federal legislation that allows lenders with federal bank charters from locating in states such as Delaware and South Dakota that allow them to export uncapped interest rates.

Warren suggests it’s time to create a Financial Product Safety Commission (FPSC), which would be charged with reviewing new credit products for safety and requiring modification of dangerous products.  It would evaluate mortgages, credit cards, car loans and other forms of credit and review such things as unlimited and unexplained fees, inordinately high interest rates increases, and claims by issuers that they can change the terms after money has been borrowed.

Interestingly, the Federal Reserve and other regulatory agencies have just proposed regulations to limit some of the most egregious credit card practices.  Similar prohibitions against excessive fees and interest rates have been proposed in Congress by Sen. Christopher Dodd, D-CT, and Rep. Carolyn Maloney, D-NY.   Hilariously, the banking industry is fighting the move and saying it will hurt consumers.

All of this sounds like a great start, although I wouldn’t get my hopes up that any of it will make more than a small dent in the credit problem in America.  It’s not clear from Warren’s article, for instance, whether she believes the FPSC would have power to do more than evaluate and make recommendations about unscrupulous and dangerous credit practices.  And as she also points out:

Unfortunately, in a world in which the financial-services industry is routinely one of the top three contributors to national political campaigns, the likelihood of quick action to respond to specific problems and to engage in meaningful oversight is vanishingly slim. 

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We’re halfway through the credit crisis

Posted by David Kassel on April 20, 2008

We’re about halfway through the current mortgage credit crisis, and it will take a combination of self-discipline from the financial markets and government intervention and regulation get us the rest of the way through it.

That’s the message I took from Robert R. Glauber, a former chairman and CEO of the National Association of Securities dealers, who discussed the origins of the crisis and  what needs to be done to end it, in a seminar at the Harvard Kennedy School last week.  Glauber described the credit crunch as “an accident waiting to happen.”

He noted that housing prices have dropped 10 percent in the past year and are projected to drop another 10 percent until possibly well into 2009.  Mortgage delinquencies will continue.  Projected losses due to defaults in the subprime mortgage market could reach $300 billion.  But Glauber doesn’t think it will end there.  Another $200 billion in defaults on commercial real estate loans are likely among other losses.

He compared the “credit bubble” to the “dot-com” bubble of the late 1990s.  In both cases, Wall Street had “manufactured” companies as investment opportunities.  In the current crisis, hedge funds invested in mortgage securities.  Regulators allowed investment banks to create highly leveraged, off-balance-sheet investment mechanisms that were built on subprime mortgages.  It was a natural thing to do because there was a trillion-and-a-half dollar supply of those mortgages around.  This created a housing bubble, which started to collapse at the beginning of 2007.

How will it all end?  Two things have to happen, Glauber says: One, the markets, aided by government, have to stop the downward spiral of contracting capital markets.  The feds have started this to some extent by lending to investment banks.   Glauber termed it a “major step” in easing fears among banks and investors.

Secondly, investment banks have to write down their assets and raise new capital.  The problem is that the banks are reluctant to take that second step.  They’ve gone about halfway, but they are waiting for the cost of capital to bottom out.  

Meanwhile, the U.S. Treasury has proposed a “Blueprint” for tighter regulation of Wall Street, including standards for mortgage participants and the first ever regulation of hedge funds and private equity funds.

Thus far, Glauber said, the markets haven’t done a very good job in policing themselves.  The question is how much additional regulation will be needed to supplement market discipline.  That regulation can range from information gathering to systemic controls on investment banks and other mortgage institutions.  Glauber suggested that the line should be drawn between institutions that are federally insured (they should have more regulation) and those that aren’t (not as much regulation needed).

Glauber also acknowledged that part of the reason for the mortgage crisis involves a conflict of interest on the part of ratings agencies such as Standard & Poors, Moody’s, and Fitch, which investors relied on to rate mortage-backed securities.  Those ratings agencies are paid by the issuers of the securities to rate them.  But the conflict may not explain the whole thing.  The argument can be made that the magnitude of the mortgage defaults have turned out to be so massive and unprecedented that the ratings agencies could never have predicted it.  Even if the ratings agencies had considered the the most dire data they had on the securities they were rating, they would have missed the crisis by a factor of three, he said.


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