MONEY Citigroup

Here’s Why Citigroup Is Shelling Out $7 Billion

It wasn't just investors who were hurt when banks turned lousy mortgages into toxic bonds

+ READ ARTICLE

You could be forgiven for not caring — or perhaps not even noticing — that Citigroup agreed yesterday to pony up $7 billion to settle a Justice department inquiry into its mortgage business. More than five years after the financial crisis, the legal process of holding banks accountable can feel about as urgent as a rerun of Law & Order.

But it’s worth spending a few minutes remembering what actually happened — and who got hurt.

The government’s case against Citigroup is about harms to investors who bought pieces of mortgage “pools” that Citi created. But since investors who buy mortgage securities aren’t exactly Joe and Jane Mainstreet, the whole thing can seem almost victimless. The financial press also tends to overlook the human costs and focus on the money: What does the $7 billion hit mean for Citigroup’s share price? (So far, investors seem happy to at least know the bill.) Who gets the money? (Mostly the government, but $2.5 billion will go to consumer relief, like mortgage modifications.) And who is paying? (Shareholders, basically. No individuals from the banks are paying up—at least in this settlement.)

So it’s easy to forget that actual homeowners were hurt, too. Citigroup was one link in a chain that turned home loans into investment products. At one end, there were the original mortgage lenders (including such fine operation as Countrywide). Citigroup would buy mortgages from the originators and then pool the loans together to create securities that other investors could buy. One of the bank’s jobs was to make sure that the mortgages in the pool were up to snuff.

Citigroup hired outside companies to check on this. The companies would look at a sample of the loans and see if any of them didn’t fit guidelines, or if valuations of the homes the mortgages backed looked squishy. The news Citigroup got back wasn’t pretty. One Citigroup trader looked at the reports produced and wrote in an email (one for the ages) that “we should start praying… I would not be surprised if half of these loans went down.” Nevertheless, Citigroup went ahead and created securities out of the loans. These securities went south, touching off the Great Recession.

But things didn’t work out terribly well for the individual borrowers, either. Citigroup and institutions like it helped stoke mortgage originators’ appetite to lend to just about anybody and everybody, in many cases based on unrealistic valuations. The damage from this includes borrowers who ended up overstretched and put on the road to foreclosure, and more broadly any home buyer who bought into a increasingly inflated market.

Let’s not forget that part.

TIME Companies

Citigroup Settles Subprime Mortgage Case for $7B

WASHINGTON (AP) — Citigroup will pay roughly $7 billion to settle an investigation into risky subprime mortgages, the type that helped fuel the financial crisis.

The agreement announced Monday comes weeks after talks between the two sides broke down, prompting the Justice Department to warn that it would sue one of the nation’s biggest banks.

The settlement stems from the sale of securities made up of subprime mortgages which fueled the boom and bust that triggered the Great Recession in 2007.

Citigroup, among other banks, downplayed the risks of subprime mortgages when packaging them selling them to mutual funds, investment trusts, pensions, as well as other banks and investors.

J.P. Morgan is the only other major U.S. bank to settle so far, though Bank of America is reportedly in talks to do so.

MONEY

Does Anybody Need a Money-Market Fund Anymore?

New regulations are meant to protect money market mutual funds from another 2008-like panic.

On Thursday, the Wall Street Journal reported that the Securities and Exchange Commission is expected to approve new regulations for money-market mutual funds. Remember money-market funds? Before the financial crisis, these funds were very popular places to stash money because each share was expected to maintain $1 value. Your principal would remain the same, and the fund would pay substantially higher interest rates than a bank savings account.

But these days for retail investors, money-market mutual funds are something of an afterthought.

So why is the SEC intent on regulating them now? And will tighter rules push them further into irrelevance? Here’s what you need to know:

What going on?

A money-market fund is a mutual fund that’s required by law to invest only in low-risk securities. (Don’t confuse funds with money-market accounts at FDIC-insured banks. These rules don’t affect those.)

There are different kinds of money-market funds. Some are aimed at retail investors. So-called prime institutional funds, on the other hand, are higher-yielding products used by companies and large investors to stash their cash. The big news in the proposed rules affects just the prime institutional funds.

Prime institutional funds would have to let their share price float with the market, effectively removing the $1 share price expectation.

The SEC reportedly also wants to impose restrictions preventing investors from pulling their money out of these funds during times of instability, or discouraging them from doing so by charging a withdrawal fee. It’s unclear from the reporting so far which kinds of funds this would affect.

Why is the SEC doing this?

As MONEY’s Penelope Wang wrote in 2012 when rumors of new regulations were first circulating, the financial crisis revealed serious vulnerabilities to money-market funds. When shares in a $62 billion fund fell under $1 in 2008, it triggered a run on money markets.

In order to stabilize the funds, Washington was forced to step in and offer FDIC insurance (the same insurance that protects your bank account). That insurance ran out in 2009, and now the funds are once again unprotected against another run.

The majority of the SEC believes a primary way to prevent future panics is to remind investors that money-market funds are not the same as an FDIC-insured money-market account at a bank. Before the crisis, the funds seemed like a can’t-lose proposition. The safety of a savings account with double the return? Sign me up. But as investors learned, you actually can lose.

What does it mean for you?

Not much, at least not right away. The floating rate rules only apply to prime institutional funds, which the Wall Street Journal says make up about 37% of the industry.

The change also won’t be very important until money-market funds look more attractive than they do today. Historically low interest rates from the Federal Reserve have actually made conventional savings accounts a more lucrative place to deposit money than money-market funds. The average money-market fund returns 0.01% interest according to iMoney.net. That’s slightly less than a checking account.

Investors have already responded to money funds’ poor value proposition by pulling their money out. In August of 2008, iMoney shows there was $758.3 billion invested in prime money fund assets. In March of 2014, that number had gone down to $497.3 billion.

Finally, it appears unlikely that money-market funds will ever be as desirable as they were pre-crisis. As the WSJ’s Andrew Ackerman points out, money funds previously offered high returns, $1-to-$1 security, and liquidity. Interest rates have killed the returns, and the new regulations will limit liquidity and kill the dollar-for-dollar promise.

Don’t count the lobbyists out yet

Fund companies are really, really unhappy about the SEC’s proposed regulations. They’ve been fighting the rules for years, and until there’s an official announcement, you shouldn’t be sure anything is actually going to happen.

Others are worried the new regulations, specifically redemption restrictions, might actually cause runs on the market as investors fear they could be prevented from pulling money out if things get worse.

But the SEC may have picked a perfect time to do this. With rates so low, few retail savers care much about money-market funds. That wasn’t true back when yields were richer and any new regulation of money-market funds might have been met with a hue and cry from middle-class savers. Today? Crickets.

TIME Management

JP Morgan CEO Has Throat Cancer

Jamie Dimon told employees the disease is “curable”

+ READ ARTICLE

Investment banking firm JP Morgan’s CEO Jamie Dimon told staff Tuesday that he has throat cancer.

“The good news is that the prognosis from my doctors is excellent, the cancer was caught quickly, and my condition is curable,” Dimon, CEO of the bank since 2005, said in a note to staff.

Dimon said the disease will require about eight weeks of radiation and chemotherapy treatment, CNBC reports.

“I feel very good now and will let all of you know if my health situation changes,” he said.

Dimon steered JP Morgan through the financial crisis but met with controversy after the bank was involved in a scandal in 2012, leading to billions of dollars in losses and calls for Dimon’s ouster. The notoriously blunt bank chairman was criticized for calling the fiasco a “tempest in a teapot.”

[CNBC]

MONEY Housing Market

How to Stop the Next Housing Bubble

Housing development under construction on farmland, aerial view.
Housing development under construction on farmland, aerial view. Ryan McVay—Getty Images

The financial system is still too risky. Step one toward fixing that: Rethink mortgages.

More than five years after the Lehman Brothers collapse, America still has a bubble problem.

The economy is improving, but the country is still poorer and less busy than it should be this long after the official end of the Great Recession. Here’s where actual GDP lines up against where it might be if the economy had returned to its normal path:

image(25)
SOURCE: St. Louis Fed, Congressional Budget Office

Despite this gap, the Fed last week announced it was continuing to slow down its massive program of bond buying known as “quantitative easing,” which was designed to ease lending and goose the economy. The central bank is keeping short-term interest rates near zero, but many economists and economic pundits still think the Fed should be even more aggressive, rather than slightly less so. The Fed holds back mostly out of fear of inflation (which remains low) but another worry has emerged: Investors are getting cocky. Stocks are way up, bond investors are buying riskier stuff in a “reach for yield,” and yet a gauge of market mood called the “fear” index is registering an unusual lack of anxiety.

The Fed has expressed concern, at least in a keeping-it-on-our-radar way. “There is some evidence of reach-for-yield behavior,” said Janet Yellen on Wednesday in a press conference.

That doesn’t mean we’re in bubble territory. Even if a market drop is coming, there’s a difference between that and a systemic crisis like 2008′s; Yellen said she isn’t seeing a rise in dangerous financial leverage. But that we’re even having this conversation is a sign that there is a lot of unfinished business left over from the crisis. There’s still too much risk built into the financial system.

This story is the first in a series I’ll be writing for Money.com about ways to prevent future bubbles—or at least to limit the damage when they pop. There are numerous pieces to this puzzle. Banking regulations, consumer protections, Fed policies, and broad-based economic growth are all important for a healthy financial system.

But the most obvious place to start is literally close to home: Mortgages. The 2000s saw an enormous build up in household debt, largely driven by home loans.

SOURCE: Federal Reserve

A lot of attention has been paid to how crazy a lot of those mortgages were. There were “NINJA” loans (no income, no job or assets), no- or low-downpayment mortgages, and exploding ARMs that started with low teaser payments. Such loans are impossible or at least very hard to get now. But a pair of fascinating new books make the case that there’s still a basic flaw in how mortgages work, one that Washington had a golden opportunity to fix but failed to. Put simply, home loans are far too difficult to renegotiate when things go badly wrong.

Over the years I’ve read a tall stack of books about the financial crisis. Other People’s Houses, by Vermont Law School professor Jennifer Taub, provides the clearest, beginning-to-end explanation I’ve seen of what went wrong. And Taub’s beginning is a surprise: A 1993 Supreme Court decision about how bankruptcy law applies to mortgages.

A mortgage on your primary residence is different from other kinds of loans–and not in a good way. When a borrower is buried in bills, the bankruptcy process can help discharge many kinds of debt. In the early 1990s, Harriet and Leonard Nobelman found themselves underwater on a condo in Dallas—they owed more than $65,000, but the current market value had fallen to $23,500. As part of a bankruptcy plan, they proposed that the balance of their mortgage be reduced to that $23,500. The bank fought this in court. Ultimately, the Supreme Court decided that the principal value of a mortgage can’t be modified by a judge in the bankruptcy process.

Fast forward to 2008 and the housing crisis, and this technical-sounding decision suddenly mattered a lot. Candidate Barack Obama endorsed changing the bankruptcy law, but ultimately nothing ever came of it. And the administration resisted other proposals—coming from political conservatives as well as liberals—to encourage or push lenders toward principal reductions. (A program to subsidize some principal mods began in 2010.)

“Hang on,” you may be saying, “forcing people into bankruptcy doesn’t sound like much a solution. I know lots of people who went underwater on their home, and they never would have declared bankruptcy.”

That’s true. But Taub tells me that that this law matters even for those who never go to court. “It would have shifted the bargaining power,” she says. “Knowing that would be an option would have brought the lender to the table more quickly and more willingly.”

Of course, many underwater homeowners ultimately did get out from under their debts—by letting the bank take the house, or agreeing to a short sale and moving out. But could a more orderly, less painful principal reduction process have made the housing crisis less damaging?

Economists Atif Mian of Princeton and Amir Sufi of the University of Chicago say yes. Their book House of Debt argues that the Washington’s failure to help more homeowners renegotiate their debt needlessly prolonged the economic slowdown.

When households are weighed down by debt they can’t pay, they spend less, and the effect can spread throughout the entire economy. This seems intuitive, but most economists have preferred to focus on fixing broken banks. Mian and Sufi have found compelling evidence that homeowners’ woes were the real main event. For example, in U.S. counties with the sharpest declines in net worth during the crash, spending fell almost 20%.

Much of this is water under the bridge now. But not all of it. Taub points out that foreclosures are up over last year in some states. In any case, she argues that resetting the rules for how mortgages work could help to prevent the next bubble. “Hopefully, lenders, if they are disciplined by having to take losses, won’t engage in these no-money-down and no-doc mortgages and so on,” she says.

Letting off the hook people who borrowed too much is touchy stuff. (See Rick Santelli’s famous CNBC rant.) But if borrowers should be more cautious, so too should lenders. Although putting more risk on lenders might raise the cost of mortgages somewhat, Taub argues “that’s reasonable insurance to pay to avoid massive foreclosures and abandoned houses and the whole downward spiral.” You didn’t need to have an option ARM on an oversized house to feel the pain of the foreclosure crisis.

Mian and Sufi have another proposal for future mortgages that bypasses these hot-button fairness questions. A new kind of loan, called the “shared responsibility mortgage” could link mortgage payments to an index of local housing prices. If local prices fall, a borrower’s monthly nut would drop too. In return, the bank would get 5% of any capital gains on sale. The idea is both to ease the economic damage housing declines cause, and to give lenders an extra incentive to be careful about lending into frothy markets. (The tax code would likely have to be changed to make such loans popular.)

As Mian and Sufi point out, mortgages looked like a pretty safe investment from the point of view of lenders. That was a big part of the problem. Even if housing prices fell, lenders assumed homeowners would be obligated to make their full payments. But the economy as whole would have been safer if more of the risk was shared.

TIME Puerto Rico

The Next Financial Catastrophe You Haven’t Heard About Yet: Puerto Rico

On Tuesday, the island sold $3.5 billion in new debt. But the crisis still poses a danger to everyday U.S. investors

+ READ ARTICLE

Until recently, Puerto Rico was an investors’ tax heaven, renowned for its sandy beaches and killer rum. But the island is in dire financial condition and thousands of U.S. mom-and-pop investors may lose a big part of their savings if the small territory goes bankrupt.

It all started with an over-borrowing spree that lasted for decades. It ended with an island of fewer than four million residents accumulating $70 billion dollars in debt. That is a debt per capita of around $10,600 – or 10 times the median for U.S. states, according to the ratings agency Standard and Poor’s.

Puerto Rico’s over-borrowing was facilitated by an eager group of U.S. investors. U.S. mutual funds were more than willing to buy Puerto Rico bonds, because the island has a special financial advantage: its bonds are triple tax-exempt, which means that bondholders do not pay federal, state and local taxes for their coupon income (i.e. interest) from the bonds.

This created a large buyers base for Puerto Rico’s bonds, which encouraged the commonwealth to keep issuing debt. As a result, today around 70 percent of U.S. mutual funds own Puerto Rico securities, according to Morningstar, an investment research firm that specializes in data on mutual funds and similar investment offerings.

But Puerto Rico did not handle prudently enough this easy cash flow that was coming in. “For years, Puerto Rico practiced deficit financing, which essentially means taking out long-term debt to cover short-term financial needs; this was created by too much spending relative to revenues,” says municipal bond market expert Chris Mier, chief strategist at Loop Capital, an investment bank and advisory firm.

“This is unsustainable from an economic policy point of view in the long run, but since the ratings remained above investment grade, the buyers of the debt did not worry excessively,” says Mier.

The spark that lit the fuse came in 1996, when President Clinton repealed legislation that gave tax incentives for U.S. companies to locate facilities in Puerto Rico. The island’s economy began to sputter, and after the great recession, the decline in the island’s governmental finances continued.

At at time when the island is experiencing steady population loss and very low productivity, the unsustainability of unbalanced budgets and rapidly growing debt became increasingly evident.

Then the downgrades came: in the past several years, ratings agencies gradually downgraded Puerto Rico’s debt notch by notch. And the island’s government continued to promise investors that it would pass a balanced budget – something that has not occurred in over a decade.

To make things worse, a “brain drain” is occurring, as young qualified professionals are fleeing an unemployment rate of 15.4%, compared to the 6.6% federal unemployment rate, according to the U.S. Bureau of Labor Statistics. The fact that Puerto Ricans are U.S. citizens makes migration much easier and appealing, says Puerto Rican consultant Heidie Calero, president of Calero Consulting Group.

Currently, Puerto Rico’s population is 3.7 million on the island, versus 4.9 million Puerto Ricans living on the U.S. mainland. The U.S. Census Bureau projects that the island’s population will drop to 2.3 million in 2050.

“Around 51 percent of the island’s population is on welfare. How do you make them participate in the economy?” asks Calero. The size of the island’s “underground economy” was recently estimated at approximately $20 billion; and that is just an approximation since nobody really knows how much revenue goes unaccounted for, says Calero.

In February 2014, all three major ratings agencies downgraded Puerto Rico’s debt to below investment grade, widely referred to as ”junk” status in bond market circles. This indicates a greater risk of possible default or a debt restructuring. For U.S. investors, this means that the crisis in Puerto Rico will have a severe impact, not only on Wall Street but also on thousands of mom-and-pop investors.

The decline in market value of Puerto Rico bonds has reduced the value of investors’ holdings by at times as much as 35%, says Mier. But Mier cautions that there are many possible scenarios, including favorable ones where Puerto Rico succeeds in resolving its budget and debt problems and returns to investment grade ratings.

But to do that, the government needs to balance two seemingly conflicting goals: economic growth and fiscal austerity, says economist Carlos Soto-Santoni, president of Nexos Económicos, a Puerto Rico-based consulting firm, and deputy advisor for former Governor Rafael Hernández Colón’s administration.

In 2013 alone, the government passed $ 1.36 billion in new taxes. While this increases the government’s revenue, it makes doing business on the island more onerous – which in turn further impedes economic growth, says Soto-Santoni.

Solving the economic puzzle will determine whether Puerto Rico will be for the U.S. what Greece was for the European Union.

Ellie Ismailidou is a reporter for Debtwire Municipals

MONEY

Financial Reform Roundup: Banks “Built on Sand”

Financial reform news from around the Web:

  • One columnist asks whether it’s too soon for financial reform. He argues that before rushing to pass a bill, Congress should finish investigating the causes of the financial crisis. [The Atlanta Journal-Constitution]

Follow MONEY on Twitter at http://twitter.com/money.

Your browser, Internet Explorer 8 or below, is out of date. It has known security flaws and may not display all features of this and other websites.

Learn how to update your browser