Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession

by Frederick Sheehan

  23 O’Brien and Lee, “A Seismic Shift.”

  24James B. Lockhart III, acting director, Office of Federal Housing Enterprise Oversight, “OFHEO’s Special Report of the Special Examination of Fannie Mae,” before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, June 15, 2006.

  The models purchased by Fannie Mae to achieve earning targets were corrupt. Given how models are worshipped, it’s a wonder that the models weren’t thrown in jail. A 2004 OFHEO report cited a “March 1999 memorandum from an employee in the Controller’s Department [that] described the benefits of a particular brand of software for modeling amortization, noting the software allowed a user to ‘manipulate factors to produce an array of recognition streams,’ which ‘strengthens the earnings management that is necessary when dealing with a volatile book of business.’ ”25

  In 2006 testimony before the Senate, acting OFHEO Director James Lockhart reported: “Fannie Mae’s management directed employees to manipulate accounting and earnings to trigger maximum bonuses for senior executives from 1998 to 2004. The image of Fannie Mae as one of the lowest-risk and ‘best in class’ institutions was a façade.”26

  The software that Fannie Mae bought was designed by another company to disguise the truth about quarterly earnings.27 Raines received a higher bonus. Multiply this software design a thousandfold. Multiply the bonus chasers across financial organizations a thousandfold. That goes along way to explaining why Wall Street needed a bailout.

  The “quants” or “geeks” or “nerds” wrote computer programs to bundle hundreds of mortgages into a single security. This was another wonder of technology. The math and physics Ph.D.s built their models; the models were simply a product of the quants’ assumptions. Their models showed that a bundle of subprime loans, when combined and overcollateralized, were among the most creditworthy securities: AAA. It was important for a security to be awarded a very high rating, since, among other reasons, a big chunk of mortgage securities are sold to large institutions that will buy (and hold) only securities above a certain grade.

  The bank must acquire a rating for the securities from an independent party. The credit-rating agencies—S&P, Moody’s, and Fitch—were paid by the banks to rate the securities created from bundling the mortgages. Often the quants, geeks, and nerds at the agencies found themselves in agreement with the banks’ model makers. Many of these AAA-rated bonds are in default, a consequence of bond holders not receiving interest payment from the subprime borrowers (e.g., for a house, a car, a student loan) The credit-rating agencies, banks, and Fannie Mae created or bought models that distorted reality. The math worked when house prices rose. When prices fell, overcollateralized securities defaulted.

  25 Office of Federal Housing Enterprise Oversight, Office of Compliance, “Report of Findings to Date: Special Examination of Fannie Mae,” September 17, 2004, p. iii.

  26 Lockhart, “OFHEO’s Special Report of the Special Examination of Fannie Mae,” p. 2.

  27 Office of Federal Housing Enterprise Oversight, Office of Compliance, “Report of Findings to Date: Special Examination of Fannie Mae,” p. iii.

  Congress and Fannie Mae

  Congress made loud noises. It held hearings. Reform legislation was passed in committees. There, it died.28 Three years of winks and mirrors followed before the government officially took Fannie and Freddie under its wing in September 2008. Between 2004 and 2008, politicians, commercial banks, rating agencies, and investment banks suspended their disbelief and pretended that all was fine. Wall Street and Greenwich hedge funds finance many congressional reelection campaigns.

  The credit agencies belatedly lowered their AAA ratings. In May 2007, 16 of 27 brokerage houses still had a “buy” recommendation for Fannie Mae, even though Fannie had not yet produced a financial statement for 2006.29 The investment banking side of brokerage cherished their relationships with the GSEs. A firm that was unable to package Fannie mortgages into a more complicated (and profitable) derivative would lose a substantial amount of revenue. The securitized loan market produced the most profits and the largest bonuses.

  Consumers also relied on this whirlwind of finance. From 2001 through 2005, 54 percent of U.S. borrowing had been consumer debt, more than was borrowed by corporations, the federal government, and municipalities combined.30 Much of the debt was bundled into credit-card receivables or bonds backed by mortgages. America could not buy this volume of securities since it was borrowing to spend. A solution evolved: more of the debt was sold overseas. Senior executives from Fannie and Freddie were making regular trips to Asia by 2006. A Bloomberg story from February of that year quotes Tim Bitsberger, Freddie’s newly hired treasurer. Quoted from Tokyo, he said Asia was “very important.” The treasurer went on: “Our goal is to fund at the lowest cost over a broad investor base.”31 Bloomberg reported foreigners had bought 53 percent more agency debt in 2005 than in 2004.32

  28 William Poole, president, Federal Reserve Bank of St. Louis, “The GSEs: Where Do We Stand?” January 17, 2007: “Congressional hearings were held, and GSE reform legislation was passed in oversight committees of both houses of Congress in 2004 and 2005, although no final legislation has been enacted as of this time.”

  29 Karen De Coster and Eric Englund ,“Fannie Mae: Another New Deal Monstrosity,” July 2, 2000, www.mises.org.

  30 Federal Reserve Flow-of-Fund accounts, Z-1

  Just how important foreign buying had become to the U.S. housing market was evident in July 2007, when foreigners were slowing down purchases of Fannie and Freddie debt. Department of Housing and Urban Development Secretary Alphonso Jackson made an emergency trip to meet with officials from China’s central bank: “It’s not a matter whether they’re going to do more business in mortgagebacked securities, it’s who they’re going to do business with.”33 When the Chinese government stopped buying U.S. mortgage securities in July 2008, U.S. Treasury Secretary Hank Paulson asked Congress for a bazooka: an unlimited line of credit to support Fannie and Freddie.34

  Brokerage Leverage

  It may be a coincidence, or it may not be, that the Securities and Exchange Commission removed the 12:1 leverage limit on broker-dealers in 2004.35 When Wall Street collapsed in 2008, Goldman Sachs, Merrill Lynch, Bear Stearns, Morgan Stanley, and Lehman Brothers were leveraged at 30:1 or 40:1. This allowed broker-dealers to expand their balance sheets. They absorbed much of the rising issuance of mortgage securities, which they might sell or lend to hedge funds.

  The government used other agencies, such as the Federal Housing Authority (FHA), to produce the American Nightmare. The FHA was an unusually innovative bureaucracy. Its loans—often to down-andout, first-time buyers—usually require a down payment of 3 percent to 4 percent. The FHA had taken an additional step, allowing charities to pay the down payment.

  31 Chris Cooper, “Freddie Mac’s Bitsberger Says Asia Funding Important,” Bloomberg, February 8, 2006.

  32 Ibid.

  33Josephine Lau, “U.S. Urges China to Buy MortgageBacked Securities,” Bloomberg, July 13, 2007.

  34“Paulson: ‘This Is Not Chrysler,” Wall Street Journal, WSJ.com, July 15, 2008.

  35The SEC’s “Alternative Net Requirements for Broker-Dealers That Are Part of ConsoliThe SEC’s “Alternative Net Requirements for Broker-Dealers That Are Part of Consoli AI96. The 12:1 ratio is a rough figure. See, for instance, Lee A. Pickard, “Viewpoint: SEC’s Old Capital Approach Was Tried—and True,” American Banker, August 8, 2008, p. 10.

  Nehemiah was a large charity in California. As a charity, Nehemiah Corporation of America received donations. One contributor was Countrywide Financial. Nehemiah Ministries is the economic development arm of the African Methodist Episcopal (AME) Fifth District Church. A Nehemiah representative spoke from Long Beach, California: “Homes for these young families are not just a place to lay their heads down at night. These are little prosperity factories.36 Not all Nehemiah parishioners would agree. A 2001 survey estimated that 19.39 percent of the Nehemiah-
aided mortgages were in default.37

  The Washington–New York Symbiosis:

  The Fall of Wall Street

  Wall Street did not participate much in real estate until the 1990s. The collapse of Texas real estate in the 1980s did wonders for the commercial mortgagebacked security (CMBS) market. The carcasses of malls and office buildings were swept into derivative mortgage securities by Wall Street firms. Awakened to this moneymaking market, Wall Street looked for other opportunities it might exploit.

  The Community Reinvestment Act was revised in 1995.38 Banks now had an “affirmative obligation” to meet the housing needs of the poor. By 2000, U.S. banks had committed $1 trillion for inner-city and lowincome mortgages.39

  36 Martha Irvine, “Sold! Low Interest Rates Affording Savvy 20somethings Their Piece of the American Dream,” Associated Press, January 17, 2003.

  37 Gloria Irwin, “Nonprofit Group Helps Disadvantaged Home Buyers Get Federal Loans,” Acron Beacon Journal, August 24, 2003; survey conducted by U.S. Department of Housing and Urban Development. The 19.39 percent default rate hurdled the 9.7 percent default rate of non-Nehemiah FHA loans in the same cities. Source: Office of Inspector General, Department of Housing and Urban Development, “Follow Up of Down Payment Assistance Programs Operated by Private Non Profit Entities,” 2002–SF-0001, September 25, 2002, p. iii.

  38 12 U.S.C. § 2901(a)(3).

  39Howard Husack, “The Trillion-Dollar Bank Shakedown Bodes Ill for Cities,” City Journal, Winter 2000.

  Wall Street was pleased to package and sell loans that the banks did not want. Between 1989 and 2000, Wall Street securitized and sold $316 billion of subprime loans.40 But Wall Street was impatient with the bank mortgage flows. To sell faster, the large banks and brokerage houses financed subprime lenders such as First Alliance of Irvine, California, home to Lincoln Savings and Loan. Lehman Brothers’ due diligence of First Alliance included a field trip by a Lehman vice president, who reported that First Alliance was a “sweat shop” specializing in “high pressure sales for people who are in a weak state.”41 The vice president noted that First Alliance employees leave their “ethics at the door.”42 So enlightened, Lehman lent the mortgage company $500 million and sold $700 million in loans backed by First Alliance customers’ loans.43 Lehman did not know when to stop. CEO Dick Fuld bought BNC Mortgage in 2004 and Aurora Loan Services, both in Irvine.44 Lehman was the eleventh-largest subprime lender in the country in 2005.45

  Dick Fuld does not deserve all the credit. The Wall Street Journal reported: “[T]he big banks have been snapping up subprime lenders and bolstering their own internal subprime lending units. . . . Citicorp purchased Associates First Capital, a big Dallas subprime lender. . . . Meanwhile, No.2 bank J.P. Morgan Chase … purchased the subprimemortgage operations of Advanta. . . . Bank of America. . . . ”46 The list continued. This was in 2001, when the underwriting fees from the Internet and telecom boom had shriveled. The Journal mentioned the obvious attraction: “[S]ubprime . . . can be as much as three times as profitable as their equivalent ‘prime’ products.”47

  40 Diana B. Hendriques, “Profiting from Fine Print with Wall Street’s Help,” New York Times, March 15, 2000.

  41Michael Hudson, “How Wall Street Stoked the Mortgage Meltdown,” Wall Street Journal,” June 27, 2007.

  42 Ibid.

  43 Ibid.

  44 Peter Robison and Yaiman Onaran, “Fuld’s Bets Fueled Profits, Undermined Lehman,” Bloomberg, September 15, 2008.

  45 Hudson, “How Wall Street Stoked the Mortgage Meltdown.”

  46 Paul Beckett and John Hechinger, “‘Subprime’ Could Be Bad News for Banks—Riskier Loans, Now Prevalent in Industry, Show Problems,” Wall Street Journal, August 9, 2001.

  47 Ibid.

  Even with this buying spree, Wall Street still could not create enough volume for the country to live off cashout equity. The brokerage houses needed Fannie Mae, Freddie Mac, and the mortgage lenders. These parties worked well together. Jim Johnson, CEO of Fannie Mae in the early and mid-1990s, courted Angelo Mozilo at Countrywide Credit Industries. Fannie Mae “needed volume and Mozilo was the man who could deliver it.”48 Mozilo offered Johnson loan originations, and Fannie Mae reduced the fee it charged Countrywide.49 Countrywide was not a bank. (It would buy a bank later.) It had no deposits, so it relied on warehouse lines of credit to finance its mortgage business. Bear Stearns and Lehman Brothers were among the first Wall Street firms to offer warehouse lines.50 In turn, the nonbank mortgage lenders promised the firms a percentage of their loans, which the brokerage houses bundled into securities and sold to the public.51

  Was Alan Greenspan aware of the whirlwind? Whatever the case, he made his contribution to the GrammLeach-Bliley Act of 1999, which revoked the last vestiges of the Glass-Steagall Act of 1934. This was the legislation that had separated investment banking (dealing in securities) from commercial banking (lending). The distinction had blurred over the years. Greenspan’s Fed had stimulated the new era when it permitted J.P. Morgan to underwrite debt and equity issues early in his term.52 There were still encumbrances to unfettered financial dealings by banks, a specific case being Citicorp’s merger with Travelers. The latter had a large insurance business.53 Without the repeal of Glass-Steagall, Citicorp would have been required to divest Travelers insurance functions.54 Alan Greenspan’s efforts at chipping away Glass-Steagall’s restrictions were echoed by other governmental voices after he became Fed chairman.55 Robert Rubin, cochairman of Goldman Sachs in the early 1990s, held a senior post at Citigroup after government service. He urged Congress to repeal the act from the time he was named treasury secretary in 1995.56

  48 Paul Muolo and Matthew Padilla, Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis, (Hoboken, N.J.; John Wiley & Sons, 2008), p. 112.

  49 Ibid., p. 112–113. Fannie Mae charged a guarantee fee to lenders from whom it bought mortgages.

  50 Ibid., p. 42–43

  51 Ibid. In November 2006, Salomon Brothers funded a start-up subprime lender, New Century, by allowing it to borrow $105 for every $100 New Century accounted for on its balance sheet as its loan balance. The extra $5 was to pay for New Century’s operating costs. In return, Salomon “got first peek at 70% of the lender’s first $500 million in loans for sale.” Muolo and Padilla, Chain of Blame, p. 155

  52“History of J.P. Morgan Chase, 1799 to the Present”; www.jpmorganchase.com.

  53Travelers had bought Salomon Brothers and Smith Barney, both combinations of investment banking and trading firms. “The Long Demise of Glass-Steagall,” Frontline, May 8, 2003; www.pbs.org/wgbh/pages/frontline/shows/wallstreet.

  The GrammLeach-Bliley Act (its formal name: The Financial Services Modernization Act) became law on November 12, 1999.57 Rubin had left his treasury post to join Citicorp.58 Larry Summers, treasury secretary when the act passed, claimed: “This historic legislation will better enable American companies to compete in the new economy.”59

  Greenspan, Rubin, and Summers played a major role ensuring that the wildest derivatives remained unregulated. To thrive, the mortgage machine needed such developments as collateralized debt obligations (CDO) and credit default swaps (CDS). The trio led the offense against regulation of over-the-counter derivatives. Deputy Treasury Secretary Larry Summers told Congress that any oversight would cast “a shadow of regulatory uncertainty over an otherwise thriving market.”60 Without the contributions of Greenspan, Rubin, and Summers, the credit bubble might have been a muted affair. Timothy Geithner, secretary of the treasury in 2009, served under both Robert Rubin and Larry Summers as undersecretary of the treasury for international affairs. He was president of the Federal Reserve Bank of New York from 2003 to 2009. The New York president is traditionally the eyes and ears for the Fed on Wall Street. It was during his term that the leverage and derivative operations of the major banks passed the point of no return.

  54 With possibilities of extensions by the Fed. “The Long Demise of Glass-Steagall.”
>
  55See, for instance, Alan Greenspan, “Need for Financial Modernization,” Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, February 23, 1999.

  56 http://www.govtrack.us/congress/bill.xpd?bill=s106-900#votes. Joseph Kahn,“Former Treasury Secretary Joins Leadership Triangle at Citigroup,” New York Times, October 27, 1999. From the article: “Mr. Rubin acknowledged that even while he [was] negotiating his own job with Citigroup, he had helped broker the compromise agreement repealing Glass-Steagall.” Also “Rubin Calls for Modernization through Reform of Glass-Steagall Act,” Journal of Accountancy, May 1, 1995: “Robert E. Rubin, secretary of the Treasury, recommended that Congress pass legislation to reform or repeal the Glass-Steagall Act of 1933 to modernize the country’s financial system. In testimony before the House Committee on Banking and Financial Services, Rubin said Clinton administration proposals would permit affiliations between banks and other financial services companies, such as securities firms and insurance companies.”

  57 “The Long Demise of Glass-Steagall.” The bill was signed into law by President Clinton on November 12, 1999: “President Clinton Signed into Law Today a Sweeping Overhaul of Depression-Era Banking Laws,” Reuters, November 12, 1999.

  58He had announced his decision to leave his treasury post in May 1999. Editorial, “Mr. Rubin Leaves the Treasury,” Ne w York York Times, May 13, 1999.

  59 From Stephen Labaton, “Congress Passes Wide-Ranging Bill Easing Bank Laws,” New York Times, November 5, 1999; and “Depression-Era Rules Undone,” New York Times, November 13, 1999: “‘With this bill,’ Treasury Secretary Lawrence H. Summers said, ‘the American financial system takes a major step forward toward the 21st Century— one that will benefit American consumers, business and the national economy.’”

  A flurry of large bank mergers were consummated after the GrammLeach-Bliley Act was passed. Government approval often hinged on the degree to which banks had met their “affirmative obligation” under the Community Reinvestment Act revision of 1995.61 (Secretary Rubin “had a hand in urging Congress and the White House to preserve the Community Reinvestment Act” before the GrammLeach-Bliley Act was passed.62)