Greenspan’s antiregulatory philosophy did not prevent him from working for the government, however. As an adviser to Richard Nixon’s presidential campaign in 1968, he reasoned that it was better “to advance free-market capitalism from the inside, rather than as a critical pamphleteer,” he says in The Age of Turbulence. In 1974, President Ford asked Greenspan to become the chairman of the president’s Council of Economic Advisers. “I knew I would have to pledge to uphold not only the Constitution but also the laws of the land, many of which I thought were wrong,” he writes. (He concludes, “Compromise on public issues is the price of civilization, not an abrogation of principle.”)
When he was nominated to be Fed chairman, Greenspan took the job knowing that he was “an outlier in [his] libertarian opposition to most regulation.” Therefore, he says, his plan was to focus on monetary policy and let other Fed governors take the lead on regulatory matters. That’s not really how it played out, however. Greenspan was too dominating a presence, and his views were too well known. Fed economists who believed in the superiority of market discipline tended to do well in Greenspan’s Fed; those who didn’t languished.
There is no question, looking back, that Greenspan’s Federal Reserve could have taken steps to cure the growing problems with subprime lending before they got worse. It had the authority. There was a law on the books called the Home Ownership and Equity Protection Act, or HOEPA, that gave the Federal Reserve the power to flatly prohibit mortgage lending practices that it concluded were unfair or deceptive—or designed to evade HOEPA. “The Federal Reserve [has] ample authority to encompass all types of mortgage loans within the scope of any regulation it promulgates,” wrote Raymond Natter, a lawyer who had worked on the bill when he was on the staff of the Senate banking committee.
There is also no question that the problems with subprime lending weren’t a secret. After the crisis of 2008, a common refrain arose that no one saw it coming. But that was never true. State attorneys general had filed lawsuits. Housing advocates had continually beaten the tom-toms. Repeatedly and in graphic detail, Congress and the regulators—including Greenspan—had been told what was happening on the ground.
Robert Gnaizda, then the general counsel of the Greenlining Institute, which, among other things, advocates for consumer protections for people of diverse backgrounds, started meeting with the Fed chairman in the early 1990s. He raised the problem of the many mortgage originators that existed outside the banking system and were unsupervised by any federal agency. “We won’t argue about whether federal regulators are doing a good job,” Gnaizda says he told Greenspan. “Let’s look at the unregulated lenders.”
“He had no objections other than saying he wouldn’t do anything,” Gnaizda says now. “He was very gracious and polite, but there was also an imperious quality to him.”
A few years later, Gnaizda and John Gamboa, Greenlining’s executive director, met with Greenspan again. In advance of the meeting, Gnaizda had sent the Fed a pile of loan documents, which Greenspan had read. “Even if you had a doctorate in math, you wouldn’t understand these instruments and their implications,” Greenspan acknowledged during the meeting. The Fed chairman had just given a speech in which he had famously recommended adjustable-rate mortgages. Gamboa asked Greenspan if he had an adjustable-rate mortgage. “No,” replied Greenspan. “I like certainty.”
John Taylor, of the National Community Reinvestment Coalition, was another housing activist who used to meet with the Fed. “Their response was that the market would correct any problems,” Taylor says. “Greenspan in particular believed that the market would not produce, and investment banks would not buy, loans that did not make sense. He genuinely believed that.”
But anyone who knew anything about the subprime business could see that wasn’t true. A prototypical example was First Alliance Mortgage Company, or Famco. A star of the early subprime scene, Famco went public in 1996, allowing its founder and his wife to take $135 million out of the company. Within two years, however, its abuses had become so widespread, and so well known, that several state attorneys sued to force the company to stop.
Famco’s abuses were not the result of a few bad apples; they were baked into the company’s business model. As former loan officer Greg Walling explained in an affidavit, Famco recruited top auto salesmen who knew nothing about mortgages and had them memorize something called the “Track,” which was a how-to for the hard sell. They were taught never to tell customers that a teaser rate meant their interest rate would increase. They were never to divulge the actual principal amount of the loan; if they did, the customers would be able to see the enormous fees that Famco had tacked on. The sales force, meanwhile, was highly motivated to charge the highest fees it could get away with: big commissions kicked in when the fees exceeded fifteen points. According to the Massachusetts lawsuit, an incredible 35 percent of Famco mortgages in Massachusetts had fees over 20 percent.
Did Wall Street know what was going on? You bet it did. Famco told its investors that most of its subprime loans went to people with relatively good credit—which meant borrowers were essentially being ripped off, since they didn’t need to pay a big fee to get a good rate. In 1995, Eric Hibbert, a Lehman Brothers executive, wrote a memo, later obtained by both the Wall Street Journal and the New York Times, describing Famco as a “sweat shop” specializing in “high-pressure sales for people who are in a weak state.” He added, “It is a requirement to leave your ethics at the door.”
Did Lehman Brothers then decide it couldn’t do business with a company as sleazy as Famco? Of course not. Starting in 1998—the same year the states filed suit—Lehman gave Famco a warehouse line of $150 million and helped it sell $400 million in mortgage-backed securities, according to one lawsuit. The shoddy quality of the loans seems to have been as much of a nonissue for Lehman as it was for Famco; since Wall Street was just passing the loans along to investors, it didn’t have to care whether the money would be paid back, either.
In 2000, Famco declared bankruptcy. A jury later found that the company had systematically defrauded borrowers. Lehman was found guilty of “aiding and abetting the fraudulent scheme.” But the firm’s punishment—a $5 million fine—was negligible. This was market discipline? Good practices driving bad ones out? It was just the opposite: bad practices were driving out the good ones. In the mortgage industry at least, Greenspan’s beloved theory was being blown to smithereens on a daily basis. And still he refused to do anything.
Actually, that wasn’t quite true. In the spring of 2000, Greenspan announced the formation of a nine-agency task force, including all the bank supervisors, to look into predatory lending. By then, the complaints and lawsuits had become so numerous that Washington officials could scarcely keep ignoring them. The Senate had held hearings. Three prominent senators, including Paul Sarbanes, the ranking Democrat on the Senate banking committee, introduced bills to ban predatory lending. The Treasury Department and HUD put together a National Predatory Lending Task Force. Its conclusion in a 2000 report: “Treasury and HUD believe that new legislation and new regulation are both essential.” The Federal Trade Commission started bringing cases.
Sarbanes, for one, knew the terrible damage predatory loans could do; Baltimore, in his home state of Maryland, had been hit hard by rising foreclosures, many of them the result of subprime lending abuses. But the chairman of the Senate banking committee, Phil Gramm, opposed any move to regulate subprime lending. His staff at the Senate banking committee issued a report saying that it made no sense to regulate predatory lending practices because it was impossible even to say what predatory lending was. To do otherwise, the report said, “threatens to subject those regulated to the abuses of arbitrary and capricious governmental action at worst.”
For that matter, Greenspan’s task force was more a sop to Congress than a serious effort to grapple with the problem. Actions mattered more than words, and Greenspan didn’t act. The Fed’s preferable solution seemed to be more disclosure,
so that borrowers could better understand the terms of their loans and make informed decisions. More disclosure appealed to his libertarian instincts. But as everyone in the mortgage business knew, increased disclosure had done virtually nothing to stamp out lender abuses. Over the years, there had been numerous disclosure requirements added to the law. Yet to the average home buyer, mortgage documents remained largely incomprehensible. “I don’t think there is such a thing as a real sophisticated borrower,” Bill Dallas, who founded a subprime company called First Franklin in the 1970s, told the American Banker in 1998. “Basically they put their lives in the hands of originators, and we guide them.” Phil Lehman, an assistant attorney general in North Carolina, described disclosure statutes to Fed officials in 2000 as “the last refuge of scoundrels.”
One thing the Federal Reserve was required to do under the 1994 HOEPA law was hold hearings from time to time, to gain an understanding of the latest problems in the lending industry. In 2000, it held a series of HOEPA hearings in San Francisco, Charlotte, Boston, and Chicago. For anyone trying to understand why regulators were having so much trouble dealing with predatory lending, these hearings were an illumination.
The man who chaired them was Edward Gramlich, a Federal Reserve governor. Ned Gramlich was an unusual Fed governor. Despite a stint as a Fed research economist decades earlier, he had not spent his career steeped in the intricacies of monetary policy. Public policy was his passion. He was the author of a highly respected textbook on cost-benefit analysis. Before being named to the Fed board of governors, Gramlich had been a professor at the University of Michigan, where he taught economics and public policy. He was a bighearted, self-effacing man, much beloved inside the Federal Reserve building.
Not long after his arrival at the Fed in 1997, Gramlich was asked by Greenspan to head up the Fed’s committee on consumer and community affairs. This was not a prestigious post for a Fed governor, and Gramlich knew very little about the subject. But he dove in eagerly, becoming one of the country’s leading experts on the subprime business—and one of its leading critics. In 2007, Gramlich wrote a short book entitled Subprime Mortgages: America’s Latest Boom and Bust. “In the subprime market,” he wrote, “where we badly need supervision, a majority of loans are made with very little supervision. It is like a city with a murder law, but no cops on the beat.”
Gramlich, however, was not temperamentally suited to be the cop on the beat. As the hearings opened, he explained that the purpose was to see whether the HOEPA regulations should be tightened to force lenders to “consider the consumer’s ability to pay.” Given what would happen—indeed, given what was already happening—it would be hard to think of a more important line of inquiry. Yet Gramlich’s questions weren’t so much answered as they were parried. And he was too gentle a soul to push back.
One of the people testifying that day, for instance, was Sandor Samuels, the chief legal counsel for Countrywide. He objected to the idea that borrowers should be required to disclose their income—something you would think lenders would want to know before making a six-figure loan. “Let me just say, very briefly, that we think this is a very dangerous area to get into,” Samuels replied when asked about income disclosure. “Because the reality is that, in many communities, including many minority communities and immigrant communities, sometimes it’s difficult to document income.”
Gramlich: “The obvious question is: If you can’t document the income, how … do you know they can pay the loan back?”
Samuels: “Right. And I would say that there are certain reality checks, let’s just say … if a waiter in a restaurant puts down that he or she is making three hundred thousand dollars a year, we’re going to ask what kind of restaurant they’re working at.”
Around and around they went. Every objection the Fed panel brought up to a subprime practice got the same response: cracking down would mean denying worthy borrowers the opportunity to own a home. Finally, Gramlich asked Samuels for his advice on the best way to keep predatory lending practices in check. “We believe increased competition is the key,” Samuels replied, echoing Greenspan. Wall Street simply wouldn’t buy bad loans in bulk. Wall Street, of course, was already doing precisely that.
Gramlich ended the hearings by more or less throwing up his hands. “There are many practices that might be good most of the time, but end in abuse some of the time, so it’s difficult to simply ban practices,” he said. Should the government try to discourage house flipping? If it did that, it might also prevent people from taking advantage of falling interest rates. Should it forbid balloon payments? For certain borrowers, a balloon payment might make sense. And on and on. The hearings didn’t so much end as they sputtered, ignominiously, to a close.
There came a moment—it’s not clear exactly when—when Ned Gramlich went to see Alan Greenspan. He wanted the Fed to take a more active role in policing the subprime business. And he had a specific policy idea. According to the Wall Street Journal, Gramlich thought the Fed should “use its discretionary authority to send examiners into the offices of consumer finance lenders that were units of Fed-regulated bank holding companies.” (The GAO recommended the same thing, but the Fed had formally adopted a policy of not conducting such exams in early 1998.) Such companies were major subprime lenders. Gramlich had toyed with idea of placing his proposal in front of the entire seven-member Fed board. But he decided to see Greenspan privately so as not to put the Fed chairman in an awkward spot in front of the other Fed governors.
The details of that meeting have never emerged. Gramlich died of cancer in 2007, at the age of sixty-eight. Greenspan told the Wall Street Journal that he didn’t remember much about the conversation, but it was certainly not a heated discussion. Gramlich presented his idea; Greenspan turned it aside. “He was opposed to it, so I didn’t pursue it,” Gramlich told the Journal three months before his death. He, too, proffered few details.
Yet that meeting would later become a touchstone for Greenspan’s critics. It was proof, they would say, that the Fed chairman wouldn’t take on the subprime lenders—or the larger problem of too many people getting loans they could never repay—even when asked to do so by a fellow Fed governor. And they were right. But Gramlich’s unwillingness to push Greenspan any further than the Fed chairman was willing to be pushed made it easy for Greenspan to ignore him. Shamefully, Greenspan would later publicly blame Gramlich for failing to bring the issue to the board, which, as he surely knew, Gramlich had done to save Greenspan from embarrassment.
Not long before he died, Gramlich, upset at the criticism Greenspan was starting to receive, penned a note to his old boss. “What happened was a small incident,” he wrote, “and as I think you know, if I had felt that strongly at the time, I would have made a bigger stink.” But he hadn’t made a stink. That was the point. Making a stink was simply not how Gramlich led his life, even with something that mattered to him as much as subprime lending.
Josh Rosner had also begun complaining to the Fed about subprime mortgages. By 2000, he had left his job at a mainstream Wall Street investment bank and joined a small independent research firm. Once a huge believer in the new subprime companies, he had become deeply critical of them. Companies he had invested his clients’ money in had gone out of business. He had watched the lawsuits pile up over their seamy business practices. “I unintentionally helped kill my clients,” he says today. “I was so dispirited.”
Rosner had a foreboding that went well beyond that of most subprime critics. Gramlich worried about subprime lending because it took advantage of unsophisticated buyers and often cost people their homes. But Rosner saw that the delinking of borrower and lender could have more far-reaching consequences. Well connected in Washington, he began showing up at the Fed to express his concern. Fed officials would respond by saying that it wasn’t their job to determine who should or shouldn’t get a mortgage. “I’d say, but it is the Fed’s job to ensure that the system is stable,” Rosner recalls.
There were two
essential reasons for Rosner’s fears. The first was that his close reading of the data showed that most of this frenetic mortgage lending really had nothing to do with getting people into homes, since the vast majority of subprime loans were refinancings. That was true of the prime market as well. He calculated that the dollar volume of refinancings during the 1990s was $3.4 trillion, more than the entire volume of mortgage origination in the 1980s! A little-noticed Freddie Mac study noted that more than 75 percent of homeowners who refinanced in the last three months of 2000 had taken out mortgages at least 5 percent higher than the ones they retired. They were using their homes as piggy banks. “Refinancing offers the potential to increase the absolute debt burden of the average U.S. household without materially reducing other consumer debts,” Rosner wrote at the time. Surely, he thought, all this additional consumer debt was likely to end badly.
The second reason for Rosner’s fears was that he could also see from the data that fewer and fewer home buyers were putting down 20 percent, which had long been the standard to get a mortgage. By 1999, in fact, more than 50 percent of mortgages had down payments of less than 10 percent. Angelo Mozilo, who was becoming an increasingly prominent figure in the mortgage industry, believed passionately that big down payments prevented otherwise capable borrowers from being able to own a home. For much of his career, he had fought to be able to originate mortgages with little or no down payments. And mostly, he had won. Wall Street now regularly securitized loans with down payments of 10 percent or less, and even Fannie and Freddie were allowed to buy low-down-payment mortgages (although they required a private insurer to absorb some of the risk). But Rosner picked up on yet another little-noticed study, this one by Fannie Mae, showing that low-down-payment loans triggered greater losses. “Put simply, a homeowner with little or no equity has little or no reason to maintain his/her obligations,” Rosner wrote. Having equity in one’s home was much more than a barrier keeping people from buying a home, he came to believe. It was the key to homeownership. Down payments, more than any single thing, meant that you were a homeowner.
All the Devils Are Here Page 13